2/03/2021

Weekly Note - February 3, 2021

The Long-term Trend in Prices May be Less Positive


The Exceptional Macro MRI, which is an indicator of longer-term resilience, ceased providing resilience as of last Friday (January 29). Historically, the cessation of Exceptional Macro MRI has meant that the long-term trend of stock price increases is likely to be less steep. The Exceptional Macro ceased for the DJIA but also for several other major indexes.

If you would like a reminder on the terms used – Macro MRI, Exceptional Macro MRI, Micro MRI, and their expected cycles – please see this webpage: https://focused15investing.com/language  

Background


The most important purpose of identifying the periods of exceptional resilience is to identify the beginning of a major upward trend in prices. The Exceptional Macro Market Resilience Index does this effectively. Therefore, the algorithms focus on the beginning of the period, not the end.

The research done for the Focused 15 Investing approach also showed that the end of a period of Exceptional Macro resilience is often followed by a dip in prices lasting a few weeks. Unfortunately, I have not found an effective way to respond to the end of the Exceptional Macro without sacrificing return at other times - while still adhering to the Friday trading schedule.

Beginning in late 2020, I have given the option to subscribers to increase Box #2 Cash (on the Shares-to-Trade worksheet) as soon as the period of Exceptional Macro resilience ends. Responding in this way can avoid some of the major declines identified in figure 1 below.

Figure 1 below shows the performance of the DJIA algorithms since 1990. For clarity, I have not included the DJIA or the upper risk mix for this model portfolio. The periods with the Exceptional Macro MRI are shown as red vertical lines. The key observations are:

  1. The periods of Exceptional Macro resilience are not common – most of the history shown does not have this extra source of resilience.
  2. Returns are indeed higher during the periods of Exceptional Macro resilience. This can be most easily seen in periods A, C, E, F, and G.
  3. Soon after the end of a period of Exceptional Macro resilience (after the red lines end) there is often a dip in returns. This can be most easily seen after periods A, B, D, F, I and J. Period J started and ended just before the March 2020 decline.

      Figure 1. Sample DJIA model portfolio (D5 signal), showing Exceptional Macro



This chart is on a log scale so we can see the declines in the early years. But a log scale also tends to understate the pain associated with declines. The declines after periods I (January 2018) and J (the March 2020) were painful.

Please note that increasing Box #2 Cash is optional. The return and risk of the model portfolios is strong without using this option. Also, while we might have avoided the declines of 2020 by raising cash, my reason for providing this option is because of the dips after periods D, F and I. These are most likely to be the types of losses we can avoid going forward. We may not experience a global event such as the COVID-19 pandemic for many years.

Similar Shifts Seen in Other Indexes

The Exceptional Macro ceased for the S&P500 and the Russell 1000 in addition to the DJIA. All three of are indexes for large US company stocks, so I expect them to move in similar ways in general. But their Exceptional Macros are not always synchronized to the extent that they were this last week.

The cessation of Exceptional Macro occurred for the ETFs “PBD” and “ARKK,” which we use in the add-in sleeves. While these ETFs don’t have long histories, their behavior to date suggests that their MRI are useful in anticipating resilience and performance. I believe the breadths of indexes making the shift decreases the likelihood that the shift is only because of events last week, namely GameStop trading.

In addition, I have been watching for several weeks the buildup of changes within the algorithms leading to this cessation of the Exceptional Macro. Although it seems likely that factors other than Gamestop led to the buildup, it is possible that Gamestop temporarily pushed the markets over a tipping point. I will review the results of this week’s returns to determine if the end of the Exceptional Macro was a one-week event.

A factor that could be important is the status of the Micro MRI, which measures the shortest cycle of resilience. I discuss below how this has influence my decision to suggest a 50% level for Box #2 Cash. We are likely to maintain high levels of Box #2 Cash until the Exceptional Macro re-emerges and/or we begin an upleg in the Micro MRI, which, as discussed in the section below, is still several weeks away.

Increasing Box #2 Cash to 50% Because of Near-term Vulnerability Related to Micro MRI

The reason I selected 50% as the amount for Box #2 Cash instead of a lower amount is that we are still early in the downleg of a Micro MRI cycle. Markets are likely to be more vulnerable to declines over the next several weeks regardless of the condition of the Exceptional Macro.

The Micro MRI has been making a slow peak over the last several weeks and are moving to the downleg of its cycle. For the DJIA, the Micro is at the 66th percentile of levels. All else equal, stock prices are likely to be vulnerable for several more weeks. If the Micro MRI were at lower levels in their cycles and closer to the beginning of their uplegs (e.g., at the 40th percentile or lower, for example), I would have suggested a smaller amount for Box #2 Cash.

In addition, many stock markets around the world have Micro MRIs in similar conditions. Since many of the stock indexes are beginning the downleg of their Micro MRI cycles at high levels, we can expect markets around the world to experience weakness. Also, markets being synchronized is sometimes a warning sign for major global stresses. The following stock market indexes are in the same general condition as the DJIA – their Micro MRI recently formed a peak and is still at a high level in its downleg (at the 60th percentile or higher):
  S&P500
  NASDAQ
  MSCI World Index
  Russell 2000 Small Company Index
  UK Stocks
  Europe Stocks
  Japan Stocks
  Emerging Market Stocks
  Shanghai Composite Stocks

Of course, we have a global pandemic, which is a source of great stress. Its global nature alone may account for the synchronizing economies and stock markets. However, from the perspective of our investment approach, when investors see many markets decline at the same time, the risk of panic selling increases, which tends to deepen the declines. Thus, my selection of 50% for Box #2 Cash.

Consistent with global stress and weak US stock prices, the MRI suggest that the USD will strengthen over the next several weeks. We may see heightened inflation concerns as well.
--

12/30/2020

Weekly Note - December 30, 2020

Market Resilience Index series - DJIA  

The DJIA continues to be resilient. The main Market Resilience Indexes, their directions, and levels (in terms of percentile within all weekly levels since 1918, except for the Exceptional Macro) are listed below:
  • Macro: Positive leg of cycle and moving higher; providing resilience. Currently at a low level in its cycle (34th percentile, up from 32nd last week)
  • Exceptional Macro: Present and providing strong resilience
  • Micro: Negative leg of cycle and moving lower; no longer providing resilience. Currently at a high level in its cycle (72nd percentile, down from 78th last week)

Market Comment 

As of last Friday (12/25/2020), two of the three main MRI listed above (i.e., Macro and Exceptional Macro) were providing resilience for the DJIA. If historical precedents hold true, the market will recover reasonably quickly and completely from news-related losses that may occur. There is a good chance (slightly greater than 50%) of the DJIA moving higher, despite a Micro MRI being the downleg of its cycle. This is because the Exceptional Macro is present and its strength can compensate for the lack of resilience from the Micro MRI. We have seen evidence of this phenomenon last week and so far this week – the DJIA is not declining even though the Micro MRI is the in the downleg of its cycle.  

However, the next roughly six weeks are likely to be more volatile for the DJIA (i.e., rapid price moves up and down) than it has been over the last roughly six weeks. While there is less than a 50% chance of overall declines over this period, there is still enough of a chance that we should not ignore the possibility that the DJIA will be at a lower level in six weeks. Thus, the suggested additional cash for Box #2 Cash for those with shorter investment horizons, as indicated above in section C of the weekly email, until we get further through the downleg of the Micro MRI.

Regarding the MRI conditions of global markets, many of the major stock markets are in a similar situation as the DJIA – a Macro MRI that has just moved to the upleg of its cycle, the strong presence of the Exceptional Macro MRI, and a Micro MRI that has just moved or will soon move to the downleg from a very high level. This applies to these markets: S&P 500, MSCI World Stocks (MXWO), US Industrial Stocks (S&P and DJ), US Transports, Energy Stocks (SPGS), US Small Company Stocks (Russell 2000), UK Stocks, Europe Stocks, Emerging Market Stocks, Shanghai Stocks (in USD).

This statement also applies to Bitcoin, and several commodities (excluding precious metals). Contributing to these conditions is that the US dollar continues to lack any source of resilience. The US dollar is very vulnerable to continued declines. 

The obvious omission from this group is the NASDAQ stock index. It’s Macro MRI is currently in the downleg of its cycle and is not providing resilience.

It looks like 2021 is starting with a wide range of very resilient markets, which would present a welcome change from 2020. The short-term vulnerability of the Micro MRI for these markets over the first several weeks of the year may induce some additional concerns. Should those concerns pass without negatively influencing investors globally, we will likely see global markets move quickly higher.

end

12/22/2020

Weekly Note - December 22, 2020

This post discusses the following points:
  1. Current MRI Conditions for the DJIA
  2. Near-term Outlook for Other Indexes
  3. Current Research for a Possible Replacement for the 2020 Recovery Add-in Sleeve
1. Current MRI Conditions for the DJIA

This section is an update of my comments last week about the current MRI conditions for the DJIA.

The DJIA continues to be resilient. The main Market Resilience Indexes, their directions, and levels (in terms of percentile within all weekly levels since 1918, except as noted for the Exceptional Macro) are listed below:
  • Macro: Positive leg of cycle and moving higher; providing resilience.  Currently at low level in its cycle (32nd percentile, up from 31st last week)
  • Exceptional Macro: Present and providing exceptional resilience 
  • Micro: Currently registering as positive, but beginning to shift to the downleg of its cycle. Currently at a high in its cycle (78th percentile, down from 79th last week)
As of last Friday (12/18/2020), all three main MRI were providing resilience. If historical precedents hold true, the market will recover reasonably quickly and completely from news-related losses that do occur.

Generally speaking, the Exceptional Macro is either present or not, therefore there is no level associated with it. Historically, a present Exceptional Macro a) suggests that a more positive Macro MRI will develop in the subsequent few weeks, b) occurs infrequently, and c) can fully compensate for the low resilience of a downleg in the Micro MRI cycle.

Given the importance of the Exceptional Macro at this time, I am watching it closely. If it deteriorates meaningfully and ceases to provide exceptional resilience, I will not hesitate to increase the suggested Box #2 Cash level outside of our regular trading schedule. But for now, the Exceptional Macro is present for many markets (not only the DJIA), and a more positive Macro MRI is developing as expected for these markets – an indication that many stock markets are developing stronger long-term resilience.

We can expect the Micro MRI to be in the downleg of its cycle over the next few weeks. There may be some short but painful declines associated with this status during this period, but recoveries are likely to relatively quick and complete. If historical precedents hold true, the other MRI will provide enough resilience to compensate for the lack of Micro (short-term) resilience.  But because historical precedent may not fully apply to 2020, I am maintaining my suggestion of Box #2 Cash to remain at 20%.  

2. Near-term Outlook for Other Indexes

Despite coming to the end of 2020 and hoping for a better 2021, the economic repercussions of the pandemic will be with us for a while. The shock of the economic shutdown and the steps taken by governments globally to stimulate the world economy have had extraordinary impacts on the market. These shocks will reverberate through the markets for some time. Below are some of the MRI conditions that stand out among the many indexes and markets that I monitor each week.

  • Continued resilience of stock prices – Resilience continues to build in the DJIA and other US stock market indexes, even though many are close to all-time highs. Increasing resilience is evident even for the NASDAQ, which recently had some deterioration in its long-term (Macro) resilience.
  • Investors shifting to favor value stocks compared to growth stocks – Growth stocks, such as Apple, Amazon, and Google, have had stronger returns than value stocks (such as JP Morgan, Johnson & Johnson, Walt Disney, and Verizon) over the last several months. I evaluate the relationship between growth stock indexes and value stock indexes. We are currently at an inflection point in the Macro MRI of this comparison. This suggests that value stocks will have stronger returns than growth stocks over the coming months. This shift should provide support for the DJIA-linked ETFs (DIA, DDM, UDOW) because they are biased toward value stocks. This shift has been taking place for several weeks and has been expected by many investors. But over the coming months, the outperformance of value stocks is likely to be more dramatic. If this shift does indeed become more dramatic, it would indicate an end to the useful life of the current 2020 Recovery sleeves (sg20.1 and sg20.2), which have a growth bias because of their use of the NASDAQ-linked ETFs.
  • Continued weakness in the US dollar – I mentioned in my November 18th note that this is an important factor in supporting stock prices. It appears that USD dollar weakness will continue for a few more weeks. A weaker dollar boosts the value of the foreign earnings of US companies and make US-produced goods and services more attractive globally. Many of the DJIA companies have global businesses and benefit from a weak dollar. Even smaller companies outside the DJIA benefit because their goods become cheaper to customers in other countries.
  • Continued resilience of commodity prices – Many commodities are priced in dollars, and a weakening US dollar boosts the prices of commodities, all else equal. Commodity prices can also increase because of higher expected future economic growth. At the moment, we have both a weaker US dollar and an expectation of higher economic growth in 2021. This shift is currently most easily seen in the SPGS Commodity index, for which the Macro MRI has become positive, suggesting higher commodity prices longer term.
  • Inflation concern remains low – I evaluate the relationship between the Global Inflation-Linked Bond index and the World Government Bond Index to monitor inflation concerns. The MRI dynamics of this relationship suggest inflation concerns will remain low for the next several weeks.
  • Reduced resilience (greater vulnerability) of the 10-year Treasury Bond index – I expect many model portfolios to shift out of the 10-year index-linked ETFs (IEF, UST, and TYD) over the next several weeks because of the weaker resilience of 10-year bond prices. A decline in bond prices can start to undermine the attractiveness of stocks because reduced bond prices create higher bond yields.  At a certain level of increased bond yields, stock investors may view the bonds more favorability by comparison. 


3. Current Research for a Possible Replacement for the 2020 Recovery Add-in Sleeve

The ongoing economic and market conditions related to the pandemic are likely to influence many stock, bond, and other markets through 2021. My examination of these conditions may lead to a new Recovery sleeve (perhaps called “2021 Recovery”) that would replace the current 2020 Recovery sleeve. Following are a couple of topics that I see as particularly relevant; all of these have signal sets done in the 2007-2010 period. 
  1. Possible continued strength of the NASDAQ index – I am examining the possibility that the unprecedented level of government stimulus around the world this year will lead to much higher prices for stocks than we currently observe. Some market strategists believe that government efforts in the late 1990s to recover from the Asian and Russian debt crises and a crisis related to the hedge fund Long Term Capital Management meaningfully contributed to the subsequent internet boom from the mid-1990s through 1999 and following bust. During the internet boom, the NASDAQ index far outperformed the DJIA and S&P 500. While the NASDAQ has already outperformed these indexes over the last year, the economic stimulus this year is far greater than it was in the late 1990s. It is conceivable that NASDAQ could continue to push higher.  If this occurs, the current structure of the 2020 Recovery sleeve (sg20.2) may be sufficient. 
  2. The following markets are experiencing troughs in their Macro MRI. These indexes may move higher over the next year and beyond. My current research relates to whether their expected returns will be superior to what we are likely to obtain from our main portfolios.

a. Commodities – As mentioned above.

b. Emerging market stocks and bonds – Many of these investments are based in Asia which has been spared many of the economic setbacks the US and Europe have experienced in 2020. Emerging markets also benefit from the stimulus by governments around the world. They may experience high exceptionally high returns in 2021.

c. US small company stocks – While I do expect there to be many more corporate bankruptcies in 2021, stock index ETFs have a survivor bias. Companies that go out of business are dropped from the index – only survivors remain. The stocks of surviving companies may increase in price quickly as the economy recovers.

These and other market developments may justify an updated recovery sleeve. From the subscriber’s perspective, if one elects to use an updated recovery sleeve, that sleeve would simply have different ETFs in it.

At this time, I do not anticipate changes to the main model portfolios. The DJIA-linked ETFs are likely to be stronger in 2021 than they were in 2020.

12/09/2020

Weekly Note - December 9, 2020

Current MRI Conditions and Near-Term Outlook

Resilience is increasing in stock markets around the world. The growing resilience represents a broad shift in the long-term trend of the market.  This shift does not mean that stock market prices will only go up.  Instead, it means that recoveries from declines that do occur will rebound quickly to prior price levels. 

The market resilience index that indicates the long-term cycle of resilience – the Macro MRI - is shifting to the upleg of its cycle for many stock markets around the world.  The Macro MRI for the DJIA, for example, is shifting to the upleg of its cycle and doing so at a low level – the 30th percentile of levels since 1918.  All else equal, the Macro MRI moving higher from a low level is supportive of stock prices moving higher for several quarters. 

The Exceptional Macro MRI, which appears only infrequently and foreshadows a stronger positive Macro trend is present for many stock indexes as well.  For the twelve major stock indexes I monitor closely (e.g., DJIA, NASDAQ, US large company, US small company, emerging market, China, UK, Europe, Japan) all but two have positive Macro MRI and/or Exceptional Macro MRI present at this time.  The exceptions are Japan stocks and NASDAQ, which lack both. 

However, the Micro MRI (indicating the shortest cycle of resilience) for many indexes have been positive for a few weeks and have moved quickly to the upper ends of their normal cycles.  For the DJIA, last Friday the Micro MRI was moving higher but was at the 73rd percentile of levels since 1918. Given this high level, it is likely to move to the downleg of its cycle over the next few weeks, which would in other conditions produce price declines that we would try to avoid.  But a key point for all the stock indexes in this condition is that the resilience from the Exceptional Macro and Macro MRI typically provide ample resilience to compensate for any lack of short-term (Micro) resilience. 

Based on the MRI conditions for DJIA, the algorithms conclude that stock prices may not change much or may move higher over the next few weeks.  Declines that do occur will be recovered quickly (unless there is extremely negative news). 

These conditions are most consistent with strong market performance lasting for several quarters.  I subjectively place a 60% probability of this happening. 

 

High Valuations Are Likely to Get Higher

High current stock valuations could be a headwind to further price increases.  While the MRI-based investment approach does not directly consider valuation, it does measure what investors in general are perceiving as attractive investments considering a wide range of variables, including interest rates, future earnings and current valuations.  At the moment, the MRI suggest that investors in general are not highly concerned about valuation levels.  As stock prices increase, valuation measures will likely edge higher. 

See this blog post for comments about current stock valuations (it is a revised section from the “Weekly Note - November 11, 2020” blog post): https://marketresilience.blogspot.com/2020/12/research-note-stock-market-valuations.html


The 40% Chance of Vulnerability and Deep Declines in Early 2021

It is possible that this period of resilience could be cut short, for valuation or other reasons.  If it is cut short, overall market resilience could weaken as early as mid-January. I mention this timeframe because of the downleg of the Micro cycle occurring over that time – deterioration of the long-term trend is more likely to occur during this time.  At the moment, I would place a 40% chance of deep declines occurring, and this level is still high enough to be concerned with. 

If deterioration does occur over the next several weeks, I believe it will be accurately indicated by the end of the Exceptional Macro MRI.  If this does occur, I will not hesitate to suggest raising Box #2 Cash levels outside of the regular Friday trading discipline. 

Research Note - Why NASDAQ is Not in Main Portfolios

Background – NASDAQ and the 2020 Recovery Portfolio/Sleeve

The Focused 15 Investing publications have included a 2020 Recovery Portfolio or Sleeve since April 4, 2020.  A key contributor to its return has been NASDAQ-linked ETFs.  The NASDAQ stock index has a high concentration of technology companies. The top 10 holdings of the largest NASDAQ ETF are the following.

 

Name

% Assets

Apple Inc

13.00%

Microsoft Corp

10.70%

Amazon.com Inc

10.62%

Facebook Inc A

4.42%

Alphabet Inc A

3.89%

Alphabet Inc C

3.78%

Tesla Inc

3.22%

NVIDIA Corp

2.75%

PayPal Holdings Inc

1.94%

Adobe Inc

1.91%

   Source: https://finance.yahoo.com/quote/QQQ/holdings/

The top three holdings – Apple, Microsoft, and Amazon – make up over 30% of the total ETF.  Many of companies represented in these top holdings have done well during the pandemic. 

The 2020 Recovery Portfolio/Sleeve has been a good addition to the publication in terms of performance, but for many subscribers there has not been an easy way to incorporate it into their accounts.  The recent change (Oct 30, 2020) in the Shares-to-Trade worksheet makes it easier to incorporate this sleeve. 

As shown on the weekly publications, the 2020 Recovery Portfolios have performed well since their introduction and over the last few years (in simulations).  This raises the question as to whether the NASDAQ ETFs should be permanently included in the main model portfolios. 

The bottom line is that NASDAQ has performed well in 2020, but it is too soon to conclude that NASDAQ should be permanently added to the main model portfolios. Companies prominent in NASDAQ currently have high stock valuations, and, while NASDAQ has outperformed the DJIA (which pays a central role in our main model portfolios), this outperformance may not last in a manner that we can capture it. 

The rest of this post covers:

  • An MRI-Based Analysis of NASDAQ: the performance of NASDAQ and the success of MRI-based decision rules
  • Comparison of DJIA and NASDAQ Sleeves

 

An MRI-Based Analysis of NASDAQ

At the time I designed the approach we use in Focused 15 Investing (2007-2010), the NASDAQ was clearly an important index.  Yet its price history was short (beginning in 1972) and was dominated by the internet/tech boom of the late 1990s and the following bust.  I had no trouble at that time developing algorithms that effectively participated in the upside and avoided the downside of this boom and bust.  But I had little confidence that those algorithms would be effective in future cycles because the success was proven over just one cycle. 

Instead, I developed algorithms for the NASDAQ that were informed not only by this relatively short time span but also reflected the principles that had proven useful with DJIA and other major indexes. With those algorithms in place, I have been monitoring performance of NASDAQ-linked sleeves since then. 

The graph below shows the available price history of NASDAQ.  The prominent peak is in 2000.  This chart is on a log scale to show the variability over the entire historical period.  The decline from the peak in 2000 to the low point in October of 2002 is roughly 80% — a very painful decline. 

The chart also shows a vertical blue line at the end of 2007, which is when the NASDAQ algorithms were finalized. 

The graph below shows the performance of the NASDAQ algorithms that were finalized as of the end of 2007. One can see that, overall, the NASDAQ algorithms (yellow line) performed well relative to NASDAQ buy-and-hold (red). Yet, because these algorithms incorporate principles from other indexes, they do not participate in all the upside of the NASDAQ nor avoid all the declines after the peak in 2000.

 

 

There are four important periods in this history. 

  1. From 1990 to 2000, the performance of the traded sleeve shown by the yellow line (rotating out of NASDAQ using MRI-based algorithms) underperformed the NASDAQ buy-and-hold (red). This pattern is expected in the MRI-based approach – after long positive price trends, the market tends not to decline during periods of vulnerability as investors become more euphoric.
  2. During the decline of the NASDAQ from 2000 to October 2002, NASDAQ declined in price and in the unsustainably high valuations of the late 1990s. The traded sleeve avoided some of the losses of the NASDAQ buy-and-hold but still had meaningful losses.
  3. During the period from about 2004 to about 2015, the traded sleeve had smaller losses than the buy-and-hold.
  4. During the period from about 2010 to present, the traded sleeve avoided some of the losses of the NASDAQ buy-and-hold but still tended to underperform the buy-and-hold. Underperforming on a long positively-trending market, and in both periods A and D, is not unusual for the Focused 15 Investing algorithms.
Although not shown as a separate period, one can see in the graph above that the traded sleeve had positive returns in 2020 through 11/27/2020. 

 

Comparison of DJIA and NASDAQ Sleeves

The graph below shows the performance of two sleeves.  The top sleeve (in yellow) is the DJIA sleeve using ETF DDM (DJIA x2).  The next sleeve is the NASDAQ signal set using ETF QLD (NASDAQ x2).  The lower line is a buy-and-hold mix of the DDM and NASDAQ for comparison.  As you can see, the DDM sleeve (yellow) clearly performed better than the QLD sleeve (blue line) up until the end of 2019.  For this roughly 20-year timeframe, the DJIA sleeve had superior returns.  This is especially true just after 2000, where the NASDAQ sleeve had losses (this period was marked “B” in the prior graph).  

The image also highlights the most recent performance in 2020 when the DDM sleeve moves lower and the NASDAQ sleeve moves higher.  This has been unfortunate but can, I believe, be associated with the pandemic and does not necessarily indicate a permanent shift.


If we look at the same sleeves but end the graph 52 weeks ago, we see that the DDM sleeve has a better return and lower variability. 


This is shown by the statistics in the table below. 

Return and Variability (1/7/2000 through 11/29/2019)

                                          DDM                     QLD

  Rate of Return (ann)       28.8%                    26.1%

  Variability (ann)              20.4%                    25.4%

  Ratio (RoR/Var)               1.42                       1.03

 

Now, at the end of 2020, the question is whether NASDAQ-linked ETFs should be included in the regular model portfolios.  My current thought is that 2020 should be viewed an aberration.  If we respond by changing the approach significantly to what would have worked in 2020, we may be poorly positioned for the future.  In addition, we might be simply chasing past performance only to catch price declines associated with correcting the currently high valuations, as in phase B in the graph above. 

If this view is accurate, then gaining exposure to the NASDAQ may be best done using the add-in sleeves in measured amounts as is currently available to subscribers.  The add-in sleeves allow us to move away from the NASDAQ completely during long periods of NASDAQ decline. 

Even if the NASDAQ does indeed represent companies with a more promising future than those in the DJIA, the current economic strains and NASDAQ’s high valuations make it difficult to justify a move to include NASDAQ as a permanent holding in the model portfolios right now. 

As part of ongoing research, I have a range of model portfolios that integrate NASDAQ, and so I monitor this issue.  But the best course of action right now is not to make fundamental changes in the model portfolios. 

end

 


12/08/2020

Research Note - Stock Market Valuations

Stock valuations are high compared to the historical range of the last 20 years. Common valuation measures are listed below — the higher the valuation, the more expensive the stocks. In general, one wants to buy stocks when valuations are low and sell them when valuations are high. 

  • Price-to-earnings ratio: This ratio relates the current index price to the earnings of all the companies in the index.
  • Price-to-book ratio: This ratio relates the current index price to the assets of all companies. Assets include things like factories and equipment, which are not as variable as earnings.

In the second quarter of 2020, company earnings declined dramatically because of the pandemic, but stock prices increased because Micro MRI shifted to the upleg of its normal cycle and government and Federal Reserve actions began to compensate for the decrease in economic activity and created optimism about an economic recovery.  These changes – a decrease in earnings and an increase in stock price – resulted in high price-to-earnings ratios.  Changes in the price-to-earnings ratio can be temporary because of short-term changes in earnings, such as those occurring in 2020.   

The price-to-book ratio is less sensitive short-term changes in earnings and produces a more stable valuation ratio.  However, in the current environment both valuation ratios are high compared to the last 20 years, suggesting that stocks are expensive. 

The following figure has three panels that plot DJIA data from Bloomberg. The top panel shows the price history for the DJIA (total return on a log scale), and the time period covered is 1997 through early November 2020.  Over the last 20 years, there were two major declines prior to 2020: 

  • 2002 – Decline of roughly 38% from the peak of the Internet boom in 2000.
  • 2007/8 – Decline of roughly 50% because of the Global Financial Crisis


The second and third panels show the valuation ratios for price-to-earnings and price-to-book ratios, respectively. The horizontal red lines show the current levels of those ratios. Prior to the price trough of October 2002, the price-to-earnings ratio was at a high level – a level similar to today’s.  This data point suggests being skeptical now of further price increases. 

Prior to the decline of 2007/8, the price-to-book ratio was at a high level – a level similar to today’s. This data point also suggests being skeptical now of further price increases. 

However, note that at the far left of both valuation charts, in the late 1990s, levels are higher than the current levels (indicated by the red lines). This was the end of the Internet Boom. Even though the Internet Boom primarily affected the NASDAQ index, the valuation measures of the DJIA also showed high valuation statistics as well. This early period may be a useful comparison for the current period. The shutdown measures to contain the virus have boosted the prices and valuations of stocks that are heavily weighted in the NASDAQ index, including Amazon, Microsoft, Apple, Facebook, and Google.  

While these direct historical comparisons suggest that stocks are already expensive, there are factors that may make these long-term historical valuation comparisons less relevant to the current situation.   They are: 

     Lower Interest Rates

A low interest rate environment tends to support higher valuation metrics.  At the end of January 2000, just as the Internet Boom peaked, the yield on the 10-year US Treasury bond was 6.6%.  That was the rate of return of this comparatively low-risk investment, and made bonds an attractive alternative to stocks for many investors.  In contrast, as of last Friday (December 7, 2020), the yield on the 10-year US Treasury bond was 0.9% - a far less attractive return than 20 years ago.  Thus, investors seeking returns will be less attracted to bonds and more biased toward holding stocks. 

Also, many believe that stock prices should reflect the present value of future company earnings.  The low interest rate today means that earnings further into the future are more relevant to the calculation of present value of future earnings.  A similar effect is seen in a lower mortgage interest rate allowing someone to buy a more expensive house than they could afford at higher interest rate.  Thus, the current extremely low interest rates now may tolerate higher valuation measures without being considered too expensive to purchase.  I mention an article int eh “Alternative Narratives” section below about Jim Paulsen’s view that stocks are very cheap at this point.  He arrives at that conclusion by considering today’s currently low interest rates, among other factors. 

     Fed’s Pledge

 The US Federal Reserve has pledge to keep interest rates very low for a long period of time, and also to buy assets on the open markets to reduce fears about market price declines.  The extent of the current pledge has been extreme:  In early June of 2020, Fed Chairman Jerome Powell said, “We’re not thinking about raising rates, we’re not even thinking about thinking about raising rates," conveying that interest rates are unlikely to increase before 2022, and even then, most in the Fed believe rates to remain low even into 2022 (based on the current plotting of forecasts by Fed members).  https://www.wsj.com/articles/newsletter-were-not-thinking-about-raising-rates-01591872020

     Pent-up Demand May Increase Future Corporate Earnings

Governments around the world have spent billions to compensate for reduced employment and business activity.  Less spending because of the economic shutdown plus the stimulus could conceivably produce pent-up demand.  As soon as the risk of Covid-19 reduces because of an effective treatment and/or vaccine, spending may be unusually high as people make purchases that have been delayed during the pandemic. The potential for high future demand is suggested by the personal savings rate in the US, which has moved sharply higher during the pandemic: https://www.statista.com/statistics/246268/personal-savings-rate-in-the-united-states-by-month/. While the saving rate has come down from its April 2020 high, it is still high compared to recent years.  

Thus, the current valuation statistics of the DJIA may not be excessive considering future growth related to the level government stimulus and low interest rates. 

 end

11/18/2020

Weekly Note - November 18, 2020

Last week I discussed options (see Note 1 below for a link) based on whether the market declined last week and the length of your investment horizon. The market did not decline and I list the relevant options and have added notes in italics: 

  1. You have a long investment horizon: Continue using your current model portfolio. An investment horizon of roughly 7 years or more can be considered a long investment horizon. You can disregard the guidance to hold Box #2 Cash – simply keep it at your regular amount (e.g. 3%).
  2. You have an investment horizon shorter than 7 years, and…
    • A) You are currently using one of the Onyx mixes: Continue using your current model portfolio. Follow guidance regarding Box #2 Cash.
    • B) You are NOT currently using an Onyx Mix. Consider switching to an Onyx mix model portfolio, which tend to be less aggressive and are likely to be more tolerant of a quickly weakening economic situation. Follow guidance regarding Box #2 Cash. 


As of this writing, it appears that we will make it through the current period of vulnerability this week and next without declines of more than roughly 15%.  Over the coming week(s), I will review the strength of the growing resilience and may further decrease Box #2 Cash, and, if it makes sense, for those with a short horizon (e.g. less than 7 years) to move into more aggressive model portfolios. We may be entering a period of high resilience lasting several quarters, and many subscribers may want to move to more aggressive portfolios to take advantage of this. 

Please contact me with any questions about these options.

This post covers:
  • Current Outlook Implied by Current MRI Conditions
  • NASDAQ versus DJIA
  • Valuation and Political Concerns 

Outlook Implied by Current MRI Conditions

These views do not affect the target weights of the model portfolio, but they are consistent with a broad range of MRI conditions and economic variables I review each week. When the MRI conditions change, the outlook will change.  

With multiple promising vaccines, investors can begin to focus on economic recovery in greater detail. Prior to the success of a few vaccine trials, the timing of the end of the pandemic and its related economic effects was uncertain. Now, there is increasing clarity. As you may recall from prior notes, in normal times, stock market investors try to anticipate the economic conditions that will exist 6 to 9 months in the future. Near term expected conditions have less importance. This means that the expected near-term difficulty of the pandemic and any lockdowns will have less of an impact on their decisions.

In addition to now having multiple promising vaccines, other factors contribute to optimism for economic growth in 2021. These include government economic stimulus efforts around the world, the US Fed’s promise of low interest rates for the foreseeable future, and pent-up consumer demand from months of reduced spending. 
 
Last week I mentioned that high current stock valuations are a concern. High current valuations could limit additional price gains. However, I believe the price of the DJIA will be supported over the next several weeks by the following factors:
  • Rotation of the market to industrial company stocks from technology company stocks. Technology stocks that have done well during the pandemic will underperform those that have lagged as the economy reopens. The tech-heavy NASDAQ has done far better these last months than the S&P 500 or the DJIA. The last 52 weeks of price movements is shown in Figure One below, which is discussed later. I believe the DJIA is likely to close the performance gap with the NASDAQ index over the next few months, with the DJIA moving higher.
  • The growing resilience of the DJIA. Several of the MRI for the DJIA are at inflection points and moving to the uplegs of their cycles. In addition, they are doing so at low levels in their cycles, which suggests that these uplegs may last many weeks. The Macro MRI measuring the longest cycle of resilience lasting several quarters or years is at the 29th percentile of levels since 1919 – a relatively low level. And the Exceptional Macro is now present, which is a very positive sign. The Micro MRI, measuring the shortest cycles of resilience, is beginning a transition to the upleg of its cycle at the 20th percentile since 1918. These transitions are taking place now, and, although there can be higher volatility around these inflection points, the upside for prices is greater than the downside based on these readings.
  • Weakening US dollar. In my review of the MRI conditions of 80+ indexes from around the world, the potential for a weakening dollar appears to be most imminent factor producing US stock price gains. Over the next several weeks, the US dollar will be more vulnerable to declines compared to other major currencies. As opposed to companies in the S&P 500, those in the DJIA get more of their earnings from outside the US. When the dollar weakens, the value of those earnings increases in dollar terms, which supports higher prices. This factor is in addition to the benefits of a potential end of the pandemic and the expected strengthening of the economic recovery.
I expect there to be ups and downs around the time the US Congress debates and votes on the next stimulus bill. Barring a complete failure to pass a bill, I expect the market to move higher through this period.

NASDAQ versus the DJIA

The tech-heavy NASDAQ index has returned about 45% over the last 52 weeks. The S&P500 has about 17%. The DJIA has returned just under 8% over the same time period. The pattern, especially between the NASDAQ and the DJIA fit a “K-shaped” market recovery, which I described briefly in (link: https://marketresilience.blogspot.com/2020/08/performance-review-nasdaq-valuation.html).

The forward strokes of the letter “K” can be likened to the performance of the NASDAQ (upper) and the performance of the DJIA (or S&P) (lower). The last 52 weeks of price movements is shown in Figure One below.

Figure One – NASDAQ, S&P500, DJIA – Return over last 52 weeks

The MRI statistics of the NASDAQ and DJIA index suggest that the DJIA may move higher to close the performance gap. I have already described the growing resilience of the DJIA. It is primed to move higher. The NASDAQ has quite different readings:

                                                    DJIA           Leg of cycle       NASDAQ      Leg of cycle

  Macro MRI percentile level      29th               upleg                    65th           downleg

  Exceptional Macro                    Yes (new)                                  Not present

  Micro MRI percentile level       20th              upleg                    26th            downleg


Based on these MRI and other considerations, over the next several weeks, I believe that the most likely movement is for the NASDAQ to decline and the DJIA to move higher. 

Valuation and Political Concerns

I do have concerns about the valuation of the stock market, which I mentioned last week (see Note 1, below). I wonder if investors in general believed over the past 9 months that as long as there was no vaccine, it was more likely that government stimulus would continue to expand. Now, with at least two promising vaccines, investors may be less interested in the work-from-home investment theme that has favored the NASDAQ index, and may therefore start paying more attention to valuation and growth. If this concern is justified, in early 2021 we may see more volatility in the markets as actual company earnings growth is compared with the expectation of high growth post-pandemic. However, based on historical precedents, as long as interest rates stay low the time that investors in general focus on valuation is likely a few months away. 

We also have upcoming political issues and transitions.  Passage of an additional stimulus bill is important to the stronger economic growth expected in 2021.  Should this be derailed or there are unexpected difficulties in the transition to the new US administration, growth may be slowed and be a downward force of stock prices.       

-------------------------------------------

Note

   1) https://marketresilience.blogspot.com/2020/11/weekly-note-november-11-2020.html



11/11/2020

Weekly Note - November 11, 2020

The post describes
  1. Options for Near Term (rev 11/12/2020)
  2. Current MRI conditions
  3. Recent performance of the popular model portfolios
  4. Current stock valuations

Options for Near Term


Over the last few weeks, I have described a few options for switching to a different model portfolio. I’d like to expand that description to form a few different scenarios for you to think about before the next Plant season. Thus, the options are as follows (rev highlighted):
  1. Continue using your current model portfolio regardless of DJIA prices moving higher or lower over the next week or so. This may be most suitable for people with longer investment horizons.
  2. If there ARE dramatic price declines (e.g., declines greater than 15%) over the next week or so, one can, soon thereafter, switch to a more aggressive model portfolio to take advantage of the rebound. I suspect a few subscribers will seek to do this.
  3. If there are NOT major price declines over the next week or so, one can switch to an Onyx Mix if not using one at this time. These portfolios are less aggressive and are likely to be more tolerant of a quickly weakening economic situation.

Current MRI Conditions


The Macro MRI—the MRI tracking a longer-term cycle of market resilience—has been in the downleg of its cycle since early 2018. It is now at the 29th percentile of all levels since 1918. Over the last 100+ years, there have been about 10 times that the Macro MRI troughed (i.e., turned positive) at this level or higher. There have been roughly 14 times that the Macro MRI has troughed at a lower level. From this perspective, I do expect a trough in the Macro MRI over the next few weeks.

Regarding the Micro MRI, it continues to trend lower and was at the 20th percentile of levels since 1918. It trended lower last week even though DJIA prices moved higher. The current level, like that of the Macro MRI, is at the lower end of its normal range, which suggests that a shift to the upleg of the cycle may occur in the next few weeks. Thus, the portfolios are likely to have increased exposure to the DJIA over the coming weeks.

Performance Review  


The tables below present performance figures for the most popular Focused 15 Investing model portfolios. Most of the other portfolios shown on the publications are more aggressive or more conservative versions of these.

      2020 Has Been a Challenging Year

This has been a challenging year for the model portfolios in terms of performance.

Of the five most popular model portfolios, only one (sg218) has performed better than the DJIA. The others had returns ranging from a loss of 10% to a 0% return.



The main cause of the low returns is that our portfolios became very conservative (high target weights in cash) in June and have missed the positive returns since then. The target weights followed the MRI cycles as intended, but market returns were heavily influenced by, I believe, low interest rates and massive economic stimulus from governments around the world. Their measures more than compensated for the lack of resilience in the market. The Focused 15 Investing approach explicitly avoids making bets on news-of-the-day events, which, in most environments, enhances returns. But in 2020 this has not been the case. I believe 2020 will be an unusual year and that no change in the approach should be made.

      The Onyx Sleeve Has Performed Well

The model portfolios that include the Onyx sleeve along with the DJIA-focused sleeve have performed better than those that focus just on the DJIA-linked ETFs. The first two listed are the DJIA-focused portfolios. The remaining three mix a DJIA-focused sleeve and the Onyx sleeve.

I designed the Onyx sleeve in 2013 to provide reliable returns in lower interest rate environments. Its goal is to provide consistent returns when bond returns are low. As you may recall, Onyx consists of four low volatility ETFs:
  • XLP – Consumer Staples Stocks
  • XLU – Utility Stocks
  • UST – US 7-10 Year Treasury bond index x2
  • SHY – 1-3 Year Treasury bond index
The MRI-based signals rotate target weights among these four ETFs favoring the more resilience and avoiding the more vulnerable. The recent 2-year period has been a useful test for the Onyx sleeve. While the DJIA-focused sleeve has history beginning in 1918, the Onyx sleeve’s history begins in 1991, which is quite a bit shorter. Over the last 2 years, we have had a major crisis (the pandemic) and periods of concerns about rising and declining interest rates. The Onyx sleeve has performed well during these periods, and I am confident that it can provide positive returns in a wide variety of market environments. It is important to note that Onyx has lower long-term returns than the DJIA-focused sleeves but is a good complement to the DJIA-focused sleeves. Thus, I provide Onyx mixes in all weekly publications.

While it looks like the Onyx mixes are superior to the DJIA-focused portfolios, the DJIA-focused portfolios perform better just after the Macro MRI turns positive. To illustrate this, I will show additional information for only the main DJIA-focused portfolio, Diamond (sg131), and the main Onyx mix, which is the Diamond-Onyx Mix (sg218). 

The best example strong performance after a trough in the Macro MRI over the last 20 years is 2009, just after the DJIA declined by about 50% because of the Global Financial Crisis. As shown in column B below, both the DJIA-focused and Onyx mix portfolios do better than the DJIA. But the DJIA-focused Diamond (sg131) performs better, returning 39% compared to the 27% of the Diamond-Onyx Mix (sg218).   


While the Diamond-Onyx Mix (sg218) has had better performance in 2020, Diamond (sg131) has better performance over a much longer period. The table below includes the 20-year performance figures for a set of popular model portfolios. The figure in columns C, D, and E are annualized.   



One can see that even though Diamond (sg131) has had poor performance in 2020 (year-to-date), it still has better long-term returns than Diamond-Onyx Mix (sg218).

Current Stock Valuations 

Stock valuations are high compared to the historical range of the last 20 years. Common valuation measures are listed below — the higher the valuation, the more expensive the stocks. In general, one wants to buy stocks when valuations are low and sell them when valuations are high.
  • Price-to-earnings ratio: This ratio relates the current index price to the earnings of all the companies in the index. In the second quarter of 2020, company earnings declined dramatically because of the pandemic, and this temporary shift can inflate the price-to-earnings ratio.
  • Price-to-book ratio: This ratio relates the current index price to the assets of all companies. Assets include things like factories and equipment, which are not as variable as earnings. Thus, this ratio tends to be more stable by being less sensitive to earnings fluctuations from year to year.
The following data is from Bloomberg. It shows these valuation measures for the DJIA are at high levels compared to those of the last 20+ years. The top panel shows the price history for the DJIA (total return on a log scale), and the time period covered is 1997 through early November 2020.

Over the last 20 years, there were two major declines prior to 2020:
  • 2002 – Decline of roughly 30% during the post-9/11 recession
  • 2008 – Decline of roughly 50% because of the Global Financial Crisis

The subsequent panels show the valuation ratios for price-to-earnings, and price-to-book. The horizontal red lines show the current levels of those ratios. Prior to the decline of 2002, the price-to-earnings ratio was at a high level – a level similar to today’s. 

Prior to the decline of 2007/8, the price-to-book ratio was at a high level – a level similar to today’s. The high valuation levels suggest that stocks are expensive and may not move much higher.

However, at far left of the chart the valuation, note that levels are higher than the current levels indicated by the red lines. This was the end of the Internet Boom of the late 1990s. Even though the Internet Boom primarily affected the NASDAQ index, the valuation measures of the DJIA also showed high valuation statistics as well. This early period may be a useful comparison for the current period. The shutdown measures to contain the virus have boosted the prices and valuations of Amazon, Apple, Netflix, etc., and the DJIA stocks may be affected as well.

As mentioned in prior notes, there are factors that may make long-term historical valuation analyses less relevant in the current situation. One factor is the Fed’s pledge to keep interest rates very low for a long period of time and to buy assets on the open markets to reduce fears about market declines. Also, governments around the world have spent billions to compensate for reduced employment and business activity. The personal savings rate in the US has moved sharply higher in the pandemic (link: https://www.statista.com/statistics/246268/personal-savings-rate-in-the-united-states-by-month/). As soon as the risk of Covid-19 reduces because of an effective treatment and/or vaccine, spending may be unusually high as people make purchases that have been delayed during the pandemic.

Thus, the current valuation of the DJIA stocks may not be excessive considering future growth related to the massive government stimulus and low interest rates.

Nonetheless, the issue of high valuations remains a concern because a sharp rebound of economic activity could reduce the will of the Fed and Congress to provide support. They may be less willing to extend their extraordinary support for the economy, which would remove key supports for maintaining stock prices at high valuation levels.

end





10/28/2020

Weekly Note - October 27, 2020 - Add-in Sleeves

Add-in Sleeves

Using the new add-in sleeves is completely optional. Some will decide to continue doing what they have been doing and not use them. Their current model portfolios will adjust to changes in market dynamics. If you decide not to use the add-in sleeves, simply continue using your current Shares-to-Trade worksheet; the mechanics of the sheet have not changed.

Use of the add-in sleeves is probably best suited to those who are already comfortable trading their Focused 15 investing portfolios.

I think we have a week or two before using the add-in sleeves will have an impact. This is a good time to review them and how they can be used.

My goal in creating the add-in sleeves is to make it easier to move gradually into the ETFs that have been part of the 2020 Recovery portfolios and the Emerald portfolios. The updated Shares-to-Trade worksheet allows you to continue with the model portfolio you are currently using, let’s call it your core model portfolio (or simply “core portfolio”), and at the same time allocate a portion of your account to an add-in sleeve.

On the weekly publications, I list two add-in sleeves. The first is the 2020 Recovery sleeve, which has ETFs linked to technology, healthcare, and communications stocks. The second is the Emerald sleeve, which includes ETFs for green energy and technology.

2020 Recovery Add-in Sleeve

This add-in sleeve focuses on NASDAQ, healthcare, and telecommunications stock ETFs. These ETFs are likely to be favored in the presence of social distancing and government efforts to stimulate economic recovery from the COVID pandemic. This sleeve includes ETFs linked to the tech-biased NASDAQ, the S&P Healthcare sector, and the S&P Communications sector. The ETFs will be dynamically weighted to avoid losses, although some losses will occur. The ETFs included may change over time.

We maintain two versions of the 2020 Recovery add-in sleeve, one for the Zircon, which does not use levered ETFs, and one for the Diamond and Sapphire publications, which use ETF “QLD” that magnifies the return of the NASDAQ 100 two times - essentially giving this ETF twice the market exposure of the NASDAQ 100 Index. Both 2020 Recovery versions have the following exposures to the ETFs (based on equivalent market exposures).
60% NASDAQ (ETF QQQ for the Zircon version and QLD for the Diamond/Sapphire version)
40% A mix of the ETFs VOX (telecommunications) and XLV (healthcare) ETFs

The 2020 Recovery add-in sleeve is designed to a) provide exposure to these sectors, b) avoid losses in the NASDAQ-linked ETFs (using historically tested algorithms), and c) rotate between VOX and XLV to favor the most resilient of these two sectors. This add-in is a good fit for those seeking to invest in sectors favored by the current economic and pandemic conditions.

Emerald Add-in Sleeve

The Emerald add-in sleeve focuses on clean energy and technology stock ETFs and a green bond ETF. This sleeve seeks to take advantage of what many believe is a mega-trend favoring investments in environmental sustainability.

We maintain two Emerald versions, one for the Zircon, which does not used levered ETFs, and one for the Diamond and Sapphire publications, which use ETF “QLD” that magnifies the return of the NASDAQ 100 two times - essentially giving this ETF twice the market exposure of the NASDAQ 100 Index. Both versions of the Emerald add-in sleeve have the following exposures to the ETFs (based on total market exposures).
30% NASDAQ ((ETF QQQ for the Zircon version and QLD for the Diamond/Sapphire version))
25% Clean Energy (PBD)
25% ARK Innovation (ARKK - an actively managed ETF focusing on disruptive technology)
20% Green Bonds (GRNB)

This Emerald add-in sleeve is designed to a) provide exposure to these sectors, and b) avoid losses in the NASDAQ-linked ETFs (using historically tested algorithms) and the Ark Innovation (ARKK) ETF (using a judgmental application of MRI-based disciplines). This add-in is a good fit for those with longer time horizons and/or a strong belief in the presence of the trend toward investments in environmental sustainability and who can tolerate temporary losses. THE EMERALD SLEEVES EMBODY MORE RISK THAN IMPLIED BY THE RETURN-TO-RISK CHARTS ON THE WEEKLY PUBLICATION. Some of these ETFs have short histories and are narrowly focused (PBD is focused on energy-related businesses). Also, this sleeve may be revised over time (including replacing ETFs), which will cause of restatement of historical performance figures.  Links:
   ARKK – Ark Innovation ETF. This is an active ETF, which means that the investment team at Ark buys companies that it believes will benefit from future trends. Website: https://ark-funds.com/arkk
   GRNB - VanEck Vectors Green Bond ETF. Website: https://www.vaneck.com/etf/income/grnb/overview/
   PBD – This ETF tracks the WilderHill New Energy Global Innovation Index. Website: https://www.invesco.com/us-rest/contentdetail?contentId=3dd2fd05f0e21410VgnVCM100000c2f1bf0aRCRD&dnsName=us

10/14/2020

Weekly Note - October 14, 2020

Highlights
  • A historical perspective on our missing recent market gains
  • The current status of the market (DJIA) in terms of longer-term changes in MRI conditions, focusing on the Macro and Exceptional Macro MRI
  • A comment about high current stock valuations compared to key points in the last roughly 20 years
Historical Perspective on Missing Recent Market Gains

Our portfolios have fallen behind the market, and one might ask if something in the algorithms are broken.

Focusing on the Diamond (sg131) model portfolio, it has returned -9% thus far year to date. Its Upper Risk Mix (URM) holds the same ETFs at constant weights and and the positions are very aggressive. The URM has returned 1% over the same time period.  Thus, the model portfolio is lagging the URM by about 10 percentage points so far this year. Over the last several weeks, we have been on the sidelines in cash while the market has pushed higher. I watch the markets every day and some days it is painful to see our performance shortfall.

In prior notes, I have described how the markets’ current movements have been distinctive. Specifically, the Micro MRI troughed at a moderate level in mid-July, and, based on historical precedents, the algorithms have stayed out of the stock market ETFs in the subsequent upleg. Yet as of today, this has not been profitable and has contributed to the ten-percentage point shortfall compared to the URM.

Long-Term Performance of the D5 Signal Set 

To provide more historical detail, I evaluated the 100 years of performance for the DJIA signal sets we use and compared the current shortfall (over the last 8 weeks, roughly two months) to all the eight-week rolling periods over the 100 years. The first image should be familiar, and I show it now simply for background.

This shows the DJIA in the brown line. The green line shows the performance of the “D5 signal” set that drives the target weights of the DJIA-linked ETFs (DIA, DDM, UDOW). The performance reflected by the green line does not include bond investments because bonds do not have 100 years of history. Nor does it reflect any leverage that is included in the ETFs DDM and UDOW. Nonetheless, the green line is a reasonable estimate of the value added by the MRI-based signals (based on the Macro, Exceptional Macro, and Macro MRI). The vertical dashed line shows when I started using the MRI-based approach. One can see that the D5 signal set has provided good returns over the 100-year period and also the period of actually being used in portfolios.



At the far right on the green line for the D5 signal set, one can see the recent decline related to the COVID pandemic. The D5 signal set has experienced other declines of similar magnitude and still gone on to produce a strong subsequent performance track record. The years of some of these declines are shown in the chart above.

The Shortfall

The decline in 2020 for the D5 signals set was abrupt and deep (although not as deep as for the buy-and-hold DJIA shown by the brown line). One can see that the buy-and-hold DJIA (brown line) has recovered more fully than has the D5 signal set (green line). That difference creates a performance shortfall of the D5 signal set relative to the buy-and-hold DJIA of roughly ten percentage points since the beginning of 2020.

To give an idea of how common (or unusual) this shortfall is, I have calculated the eight-week shortfalls over the last 100 years. I selected the eight-week (two month) period arbitrarily. The image below shows the performance shortfall over all eight-week rolling periods for the entire 100-year history.



The current shortfall is the third worst since I started using the MRI-based approach in 2007/8, and the ninth worst over the 100 years shown. Thus, the current period of shortfall is not unprecedented. While such a shortfall can be painful, I believe that such a shortfall is insufficient reason to modify the D5 signal set.

Current MRI Conditions – Macro MRI

I often discuss the Micro MRI because that resilience cycle fits most closely the market returns we see each day and week. As mentioned recently, the Micro MRI has been in its downleg over the last few weeks and may trough sometime in November.

In this note, I’d like to discuss the Macro MRI and how it has changed over the last few years. As a reminder, the Macro MRI indicates longer-term resilience with cycles lasting a few quarters to a few years. It is the broad market context that the Micro MRI operates in.

In early 2016, the Macro began a long upleg that lasted until early 2018. Diamond (sg131) had these returns:

  2016    30%
  2017    40%

In January of 2018, the Macro MRI peaked at a remarkably high level. It was at the 98th percentile of its levels since 1918. Since then, it has been in its downleg, indicating that the market lacked long-term resilience. Over the last 100 years, when the Macro MRI is in the downleg of its cycle, there can be deep declines. There can also be periods of strong positive performance for the market and the algorithms seek to capture these returns – but it is more difficult. My notes and comments were influenced by this negative Macro MRI backdrop, resulting in a tentative (rather than emphatic) view that the market would move higher during Micro MRI uplegs, reflecting the difficulty of achieving high returns with low long-term resilience.

  2018    -7%
  2019    33%
  2020    -9% (year through 10/9/2020)

However, today the Macro MRI is now at a relatively low level. It has declined and is now at the 32nd percentile of levels since 1918. This suggests that we are getting closer to a trough of the Macro MRI and a subsequent upleg. The lack of resilience associated with a downleg of the Macro MRI may be coming to an end over the next several weeks or months.

Current MRI Conditions – Exceptional Macro MRI

In the MRI-based framework, the Exceptional Macro plays an important role in the D5 signal set and therefore the target weights of the model portfolios. The Exceptional Macro typically indicates a change in the direction of the Macro MRI (i.e., downleg-to-upleg or upleg-to-downleg). It is sensitive to changes in the slope of the Macro and often foreshadows a peak or trough of the long-term price trend.

The image below shows the Exceptional Macro as vertical green lines on both the price line of the DJIA (upper panel) and the Macro MRI. When it appears, longer term resilience is building and the algorithms tend to favor the DJIA. When it disappears, we tend to avoid investing the DJIA.


Point A is in early 2016 when the market started a strong ascent. Point B is the peak of the Macro MRI and the beginning of a long period of low long-term resilience. The Macro MRI declined until late 2019, when it started moving higher. It did so until the Exceptional Macro appeared briefly at point C, which was just before the COVID-related decline. Between points C and D, the Macro has been in its downleg.

One can see that at points A, B, and C above that the appearance and disappearance of the Exceptional Macro often foreshadows a change in the direction of the Macro. It appeared briefly and then disappeared at point C, which was on January 31, 2020 – well before the Covid crash. A similar appearance/disappearance occurred in January of 2018. As mentioned in prior notes, guidance to adjust Box #2 Cash will be used to reduce losses associated with the disappearance of the Exceptional Macro.

The period from B to D in the image above is similar to the late 1990s when the internet bubble expanded and collapsed. In the late 1990s, NASDAQ and the DJIA moved higher propelled by internet stocks despite the Macro MRI being in the downleg of its cycle. The narrative was that the world would be remade by the internet. As prices moved higher, valuations of stocks moved higher and ultimately came to the point where price increases could not be sustained. When company earnings growth failed to materialize, prices moved lower. As they moved lower, more investors sold, pushing prices even lower.

The take-away from this example is that while we may be getting closer to the beginning of a period of long-term resilience (because the Macro MRI is at a low level – 32nd percentile), the key issue for us is what takes place between now and then.

Current Valuation Levels

While our MRI-based system does not consider valuation (e.g., price-to-earnings, price-to-book), valuation is another useful metric to assess the condition of the market. At this time, the price of the DJIA is high compared to the DJIA companies’ recent earnings and the book value of their assets. I will focus on the price-to-book ratio because earnings are questionable right now, considering the economic shutdown. The current price-to-book ratio for the DJIA is 4.6. This means that for the typical DJIA company, the current price is 4.6 times the recent book value of the company.

The last time this ratio was this high was in late 2007, just before the major decline of 2008. Before that, the price-to-book was this high in early 2000, just as the internet bubble was collapsing. Thus, when the DJIA has been at similarly high valuation measures over the last 20 years, price declines have followed. These valuation measures support us being conservative (low exposure to DJIA-linked ETFs) at this time.  That said, interest rates have been higher over the last few decades than they are now, and today’s very low interest rate environment may simply tolerate higher valuation measures, all else equal.  Thus, I do not consider this valuation level as a conclusive indicator of an imminent major decline.  


Between now and the next period of high Macro MRI resilience, we may experience price declines that move the index toward more reasonable price valuations. While our being out of the market may be painful, there are currently good reasons to stay with the disciplines and wait for the market to be more resilient.

Under Development: Add-In Sleeves

The 2020 Recovery portfolio introduced earlier this year has performed well, but switching to it was too abrupt for many subscribers. The switch would have changed the overall risk profile of their accounts to much for comfort.

I am developing a method to move more gradually into this type of special situation investment. I am creating what I am calling “Add-In Sleeves,” which a subscriber can combine with their current model portfolio in a more gradual way over time. Recall that our model portfolios have “sg” numbers, which refers to sleeve groups, such as the Diamond-Onyx Mix. “Diamond” is one sleeve. “Onyx” is another. I am making it easier for users to add an additional sleeve of their choice.

One add-in sleeve is the “2020 Recovery” sleeve. This is very similar to the 2020 Recovery Portfolio that has been in the publications for several months.

Another add-in sleeve what I call the “Emerald Innovation” sleeve. This is useful for subscribers wanting to invest in longer term mega trends such as the decarbonization of energy and technological innovation.

Users can add one of these sleeves to the current model portfolio using a modified Shares-to-Trade worksheet. They can add, say, 5% or 10% of their account into these sleeves and change this amount over time if desired.

Thus, if you currently use Diamond (sg131) and would like to add in the 2020 Recovery sleeve, you can easily do so. I will describe these sdd-in sleeves after further development over the next few weeks.

Please note that these new capabilities will not require you to change what you are doing.

J