4/12/2023

Weekly Note - April 12, 2023

Summary

The current MRI dynamics of the DJIA and the US Treasury bond indexes suggest that both stocks and bonds will move higher from here. Over the next few weeks, we are likely to see greater resilience emanating from natural sources as indicated by the drivers mentioned below. That said, the current weakness of the Exceptional Macro for the DJIA, high stock valuations, and the upcoming period of high investor excitability beginning in early June (at the latest) are the main focus of our attention for the coming several weeks.

Note: For the next several weeks, we will be holding more ETFs than usual. Over the next month or two, we will identify redundant ETFs and remove them to make trading easier. The research on the drivers has resulted in lower trading, which has made a higher number of ETFs in the portfolios more acceptable for the time being.


The Status of the Stock and Bond Markets

Please see this page for descriptions of the language used to discuss our Market Resilience Indexes® https://focused15investing.com/language

Since the end of 2021, the stock and bond markets have faced significant challenges. These include a persistent war, inflationary pressures, central bank actions to combat inflation by raising interest rates, and concerns about a possible recession caused by higher interest rates. The Federal Funds rate increased to 4.83% from a low of 0.06% in June of 2021.

Despite these challenges, the decline in the DJIA has been minimal, declining only 1% since the beginning of January 2021 through last Friday (April 7). Plus, stock valuations have remained high for the last 18 months (see this page for current valuation levels: https://marketresilience.blogspot.com/p/djia-historical-valuation-comparison.html. Many market commentators have wondered why stock investors have not sold their stocks in a panic similar to those seen in March 2020 (Covid) and 2008 (Global Financial Crisis).

From our perspective, the answer may lie in the physics-based drivers of resilience that give rise to the market fluctuations we track with the MRI. At the end of 2021, we determined that the next 12 to 18 months would be a period of low investor excitability. Market gains and losses are muted during such periods. The declines of 2008 and 2020 occurred during periods of high investor excitability, as did most of the major stock market gains and losses of the last 100 years.

The current low level of investor excitability has, we believe, resulted in the absence of significant declines in stock prices over the last 15 months. However, we anticipate that this period of low investor excitability will come to an end by the end of May, based on objective non-market drivers of investor risk aversion. After that time, we are more likely to see investor euphoria and panic and larger price swings higher or lower.

Unfortunately, it is unclear at this time whether the dramatic moves will be higher or lower. Investors may attempt to correct the currently high stock valuations by selling stocks and driving down their prices. Or they may favor stocks due to the expectation of lower future interest rates and a positive trajectory for both stocks and bonds. Based on our analysis of current conditions, the expected shift is currently toward greater in investor risk tolerance and market resilience. 

The sections below show the current MRI conditions of key stock and bond markets, which will show the generally positive trajectory for both stocks and bonds. We update our view of conditions each week and will respond as needed.   

The DJIA Over the Last 15 Months

As a way of describing the dynamics of the last 15 months, I will first show the price of the DJIA (log scale) and its Macro, Exceptional Macro, and Micro MRI. Figure 1 below shows the period from December 1, 2020 through last Friday (April 7, 2023). The upper line is the DJIA, with a vertical line on April 7, 2023 in order to highlight the current date. The scale is not shown; the important patterns to see are the relative movements of the DJIA. 

The smooth blue line is the Macro MRI. It peaked in December of 2021 (at the 80th percentile of levels since 1918), indicated by the red arrow.  It has been in the downleg of its cycle until last week when it shifted to the upleg of its cycle (at the 27th percentile), indicated by the green arrow. If we were just making investment decisions based on the Macro MRI, we would have sold the DJIA-linked ETFs in December 2021 and we would be buying now.   

Figure 1

However, our disciplines call for also considering the presence of the Exceptional Macro MRI and the cycles of the Micro MRI. 

The small vertical arrows show the presence of the Exceptional Macro. It was present from the beginning of the period shown to July of 2021 (a), and a short period in December of 2022 and early 2023 (b). It appeared again two weeks ago. 

The Exceptional Macro appears when the Macro MRI begins to shift from the downleg of its cycle to the upleg, although there are false signals from time to time. In many cases, when Exceptional Macro is present, the stock market is highly resilient and can overwhelm any vulnerability indicated by the Micro MRI. 

In the current situation the Exceptional Macro is not as strong as it normally is after major stock price declines. This condition could be rooted in the fact that we have not had a major (e.g., a loss greater than 30%) decline in the DJIA thus far.

The purple line shows the Micro MRI for the DJIA, which tracks its shortest cycle of resilience.  One can see that the DJIA price movements parallel the Micro MRI except when the Exceptional Macro is present. As expected, the Exceptional Macro overwhelms any lack of resilience stemming from the declining Micro MRI.  From this perspective, the market has performed as expected given the MRI conditions. 

These dynamics suggest that the market will be more resilient for the next several weeks and possibly months:

  • The Macro MRI for the DJIA is currently at a low level by historical norms (at the 27th percentile of levels since 1918), and has declined dramatically from the 80th percentile at its recent peak shown by the red arrow indicating the end of 2021,
  • The Macro MRI has shifted to the upleg of its cycle as of the last week
  • The last three times the DJIA’s Macro MRI troughed at this level (12/2020, 6/2016, and 9/1988) were followed 6 months later by returns of 15%, 10%, and 12%, respectively. In addition, the DJIA continued to move higher after the six-month period in each of these cases.
  • The Exceptional Macro is present.
  • The Micro MRI is a low level (34th percentile since 1918) in its normal range and is in the upleg of its cycle. 

Consistent with these MRI dynamics, the algorithms and computer model evaluating this current status are inching closer to triggering a signal to buy our DJIA-linked ETFs. However, the strength of the Exceptional Marco is not as strong as it typically is at the end of the major stock market declines of the last 100 years. We are watching closely to see the persistence of the Exceptional Macro. It has appeared sporadically over the last several months and there is a small but meaningful chance that it ceases to be present over the next several weeks. If it ceases to be present, we will reduce our exposure to the riskiest ETFs. Yet, for reasons described below it seems that there is a good chance the resilience of the stock and bond markets will follow historical norms and increase from this point. 

As you may recall from prior notes, we have identified likely drivers of the MRI.  These drivers are based on objective variables that are exogenous to the markets and affect the collective risk aversion of investors. The key advantage of these drivers is that they can be forecast into the future giving an indication of future stock market resilience. 

Figure 2 below shows the same period as the prior figure but includes up-arrows indicating the presence of the drivers. The small green up-arrows indicate the short-term driver and the larger blue up-arrows indicate the long-term driver.  The short-term driver generally corresponds to the Micro MRI and the long-term generally corresponds to the Macro MRI. 

Figure 2 

As you can see in the Figure 2 above, the end of the long-term driver and the short-term driver in late 2021 correspond to the red arrow indicating the peak of the Macro MRI. The beginning of the long-term driver in approximately 8-5-2022 corresponded to a shift in DJIA (upper line) after which the DJIA moved more horizontally. 

Conceptually, the effects of these drivers are additive and the long-term driver is stronger. When there are both green and blue arrows, we can expect investors to be more optimistic and the markets to be more resilient. 

Figure 3 below is the same as prior figures with the addition of diagonal arrows during periods when both the short- and long-term drivers are present. During these periods the DJIA avoided major declines and tended to move higher. 

Figure 3

Again, the advantage to understanding the drivers is that we can get a sense for the resilience dynamics of the coming months. You can see that after the vertical line indicating last Friday, we will be entering a period during which the short- and long-term drivers both indicate the potential for higher stock market resilience. At this time, the MRI and the drivers are in agreement: the DJIA is poised to become more resilient.

Subjectively, it appears that simply following the drivers might have been appropriate over the last 15 months; the MRI seemed to follow the drivers. However, following the MRI is typically more successful than following the drivers.

An example of this is the last time we had a major rate increases to fight inflation. The period from early 1981 through mid-1983 is similar to the current period. The period encompasses when Federal Reserve Chairman Paul Volker increased the Federal Funds rate to 20% from 11.2% in June 1981. The period also occurred during a period of low investor excitability. Figure 4 below shows the DJIA from December 1980 through April 1983 with the same markings used in the figures above. Volker increased rates at the point marked by letter A. That event coincidentally occurred at the end of the long-term driver (blue up-arrows), and occurred just before the peak in the Macro MRI, indicated by the red arrow.

Figure 4


The magnitude of the decline in the Macro MRI between the red arrow indicating the peak and the deep green arrow indicting the trough is coincidentally the same magnitude of the decline in the Macro MRI in the recent 15-month period. The change in the Macro MRI suggests that the market response to the recent rate hikes has been as aggressive as it was to the Volker rate hikes decades earlier. 

Subjectively, it appears that from the red arrow to the end of the period shown in Figure 4, the DJIA appears to follow the MRI as opposed to the drivers; the drivers were less explanatory of the change in the DJIA price. This is confirmed by a statistical analysis we performed using the drivers and data from the Daily News Sentiment Index produced by the US Federal Reserve Bank of San Francisco. The conclusions from this analysis are:

  • During the Volker period, the Daily News Sentiment Index explained a high level (77%) of the variations on the DJIA. The MRI capture the effects of news sentiment. The drivers explained a far lower level (23%).
  • During the recent period, the drivers explained a higher level (55%) of the variation in the DJIA. The Daily News Sentiment Index explained less (45%).

While the periods were similar in that they both were affected by large hikes in interest rates to combat inflation and occurred during periods of low investor excitability, the rate change in June of 1981 came after a decade of high interest rates and was more extreme in terms of a rate change. Also, a 20% short-term interest rate is conceivably more economically traumatic and newsworthy than a 4.8% rate. Perhaps the market consensus after the initial shock of inflation and rate increases is that the current period is less traumatic and will pass more quickly.

The less traumatic nature of the recent period is supported by the performance of the DJIA in both periods. Figure 5 below shows the price level of the DJIA in the two periods when interest rates increased dramatically. From the peak in the DJIA through the lowest point in the DJIA for the most recent period (red line) is at week 39, the two paths are similar.  After that point, the declines for the 1981 period continued while there has been a rebound in the recent period.  

Figure 5

The greatest loss for the two periods is similar, at a loss of 23% for the Volker period and a loss of 21% for the current period. In addition, we are 67 weeks into the current decline and the Macro MRI is shifting to its upleg. That is a similar time frame for the Volker period, which ended after 69 weeks.

US Treasury Bonds

During most periods over the last 100 years, bonds have tended tend to move higher when stocks move lower. It is this relationship the makes a portfolio that mixes stocks and bonds attractive. However, in times of rising interest rates that are likely to induce lower economic growth (like the Volker and the current periods), bonds and stocks may drop at the same time. 

Our least aggressive bond ETF is SHY, which is linked to a 1- to 3-year US Treasury bond index. Figure 6 below shows in the upper panel the performance (on a log scale) of a 2-year US Treasury bond index, which is a useful proxy for SHY. The period shown is since January of 2000 through last Friday. In the lower panel is the Macro MRI. The vertical green lines in both panels are the Exceptional Macro MRI. 

Figure 6


You can see that over most of the time period shown, the index in the upper panel moves higher, which indicates a positive return for the index. The index moved higher even in many cases when the Macro MRI moved lower. This is because of the yield on the bonds and has meant that this index and the related ETFs are good investments in most market environments. This behavior makes SHY a good default investment when other ETFs lack resilience. 

In most periods covered in Figure 6, the appearance of the Exceptional Macro indicated the beginning of a period of higher resilience and returns. In the lower panel, the appearance of the Exceptional Macro indicated a likely beginning of the Macro MRI moving higher, as expected. Recently, the Macro MRI peaked recently at the red arrow in the lower panel. The red arrow is also shown in the upper panel.  It was clear at this time that interest rates would be rising to fight inflation and this made SHY unattractive as a default investment. It made sense during this period to use higher Box #2 Cash levels as a default investment. 

The important observation in Figure 6 above is that the Macro MRI has recently begun the upleg of its cycle and has done so at a low level (green arrow).  The Macro MRI is currently at the 1st percentile of levels since the beginning of the index in 1980 – an extremely low level. We now expect SHY to function more normally as a default investment and we have taken Box #2 Cash down to a normal level. 

A similar pattern is seen for the 10-year US Treasury bond index that is a good proxy for our more aggressive bond ETFs (UST and TYD), as seen in Figure 7 below. At the end of 2020 shown by the red arrow below, the Macro MRI was at the 100th percentile since the beginning of the index in 1983. It declined to a percentile of lower than the 1st percentile at the time shown by the deep green arrow. 

Figure 7

Based on analysis of yields for the 10-year bonds (which has a longer history), the magnitude of change in Macro levels shown above would be equally extreme over the period since 1962.  The current level of the Macro MRI would be similar to the levels in the fall of 1963, early 1970, late 1966, and late 1981. These are all time times after which bonds produced high returns.   

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4/11/2023

Bitcoin

Starting April 14, 2023, we will include the Bitcoin ETF “BITO” in the Sapphire publication as a opportunistic addition. We plan to add it to the other publications over the subsequent weeks.  

The Macro MRI for Bitcoin is currently at a low level in its cycle and has recently shifted to the upleg of the cycle. Bitcoin adheres to the same principles found in our main stock and bond investments such as the DJIA and the US 10-year Treasury Bond index. To date, its price movement follows closely the cycles of optimism and pessimism tracked by its MRI.

The upper panel in the figure below displays the price of Bitcoin on a log scale from 2011 through April 7, 2023. The lower panel shows the Macro MRI for Bitcoin. The vertical green lines in both panels indicate the periods when the Exceptional Macro MRI is present. During such times, we typically see the investment increase in price more quickly and be less sensitive to the short-term periods of resilience tracked by the Micro MRI, which is not shown for clarity.

The red arrows indicate the timing of the most recent peak in the Macro MRI, and the green arrows indicate the most recent trough. The recent trough has been at the lowest point on record for Bitcoin. If the cycle moves towards its average value, the price of Bitcoin will likely increase from this point.

Bitcoin is an investment that has value simply because many investors believe it has value and there is limited supply, much like gold. Neither gold nor Bitcoin pays those who hold them dividends (like stocks) or interest (like bonds). 

However, Bitcoin's price behavior is more fully explained by its MRI than is gold's. This important attribute makes it a better fit for our portfolios than gold. 

A disadvantage of Bitcoin is its short history, which begins in 2011. Gold has been a valuable asset for thousands of years.

In addition, neither gold nor Bitcoin have valuation concerns and may respond more fully to the upward movements in the MRI without being encumbered by high valuations, which currently plague stocks. High valuations may put a lid on on stock price increases despite the markets being more resilient.  

Despite its short history, Bitcoin is sufficiently attractive to include in our portfolios because of the predictability of its price cycles. However, should it no longer follow its MRI, we will remove it from our portfolios.

3/15/2023

Weekly Note - March 15, 2023

This week's change in target weights have these effects on our accounts:
  1. Increase SHY by about 23% pts. SHY is the most cash-like bond ETF we hold
  2. Increase gold ETF GLD by about 5% pts
  3. Increase our 10-year bond ETFs (UST or TYD) by about 3% pts

The note below covers:

  1. My thoughts about the safety of accounts at Schwab

  2. Current valuation of the DJIA suggests the downward pressure on stock prices is not over

  3. A key driver of Micro MRI indicates more vulnerability to come
 

1. The Safety of Our Accounts at Schwab


I have my investment accounts at Schwab and I believe many subscribers do as well. The collapse of Silicon Valley Bank (SVB) over the last week sparked concerns about the safety of other financial institutions, including Schwab. I cannot give financial advice but my thoughts may be helpful.
  • I believe my accounts at Charles Schwab brokerage are safe.
  • It is important to differentiate between the stock of Schwab the company and the safety of investment accounts held within the Schwab’s brokerage arm.
  • The stock for the Charles Schwab Company (Ticker SCHW) has dropped in recent days, which has been widely reported in the news. As of this writing (Monday 3/15/2023) it has dropped about 30% from its recent high on January 10, 2023.
  • A decline in the price of Schwab company stock does not mean investment accounts are less secure. It does suggest that Schwab the company may have lower profits going forward because higher interest rates have affected the company’s own assets (some of which are held as bonds).
  • Investment accounts are held in the account holder’s name at the brokerage within Schwab and cannot be accessed or used by the Schwab company.
  • Investment accounts held at major brokers, including Schwab, are insured by the Securities Investor Protection Corporation (SIPC) for amounts up to $500,000 for securities (e.g., ETFs) and $250,000 in cash.
  • In addition to this insurance, Schwab has a third-party insurer as a back-up measure for the investment accounts. I was told this by phone on March 13. Schwab does not disclose the name of the insurer.
  • Schwab has a web page devoted to recent events (note 1).
    • The webpage states they have been receiving inflows from clients – including on Thursday and Friday of last week. “Our growth and momentum have continued in March, with daily net new assets of over $2 billion per trading day month-to-date, including Thursday and Friday of last week.”
    • This would be the opposite of a run on their assets.
  • The investment publication Barron’s published an opinion that the recent decline of the Schwab company stock may make the stock an attractive purchase (note 2). This would be the opposite of what has occurred at SVB and other regional banks. An attractive stock price for the Schwab company is not relevant to us because we do not buy individual stocks; we buy ETFs. It does, however, indicate that the stock of Schwab the company may be poised for a rebound after the current anxiety has passed.


2. Valuation and the Actions of the Fed Continue to Weigh on Stock Prices 


While the collapse of SVB has rattled the cages of investors around the world over the recent week, the stock market has been contending with difficult issues for many months. These include high stock valuations, high inflation, and recent interest rate increases by the Federal Reserve to fight inflation. Stock valuations remain high, inflation readings are still high, and it is not clear that the Fed is done increasing interest rates.

Focusing just on valuations, the valuations ratios of Price-to-Sales and Price-to-Book for the DJIA (based on a weighted average of all ~30 companies in the index) are both currently at the 85th percentile of levels since 2000. These high levels suggest the DJIA is still expensive and, all else equal, likely to decline.


3. A Key Driver of Micro Market Resilience Index


The decline in the DJIA we have seen over the last several weeks has been consistent with the MRI levels and what I believe are important driving forces behind changes in the MRI. See this page for a discussion of the language we use to discuss resilience: https://focused15investing.com/language

The Micro MRI, which measures the shortest cycle of resilience, has been in the downleg of its cycle for several weeks. As of last Friday (March 10, 2023), it was at the 31st percentile of levels since 1919. While low in its cycle, it can still move lower and still be moving normally. 

The Macro MRI, which measures the longest cycle of resilience is not clearly in either the upleg or downleg of its cycle; it is currently moving horizontally, which unusual. Thus, the longer-term trend of the market is not clear at this time.

Over the last few years, we have identified what we believe to be important drivers of investor optimism and pessimism. These are unrelated to the current market environment but give an early indication of how optimistic or pessimistic investors will be over the coming weeks. They therefore foreshadow how the MRI might move.

Figure 1 below shows the price of the DJIA (log scale, blue line) and the driver for the Micro MRI, labelled “Micro Driver” (green). The most recent date, March 10, 2023, is shown as a dotted vertical line. The time period covers December 30, 2022 through April 7, 2023 on the horizontal axis. The vertical scale is not shown because our focus is on the relative changes of these lines over time. The actual MRI are not shown.

Figure 1



As you can see, the DJIA has generally followed the Micro Driver over the last several weeks. If this continues, the DJIA will remain vulnerable to declines into April. Since the Macro MRI is moving horizontally (as mentioned above), it is not likely to contribute to higher levels of market resilience over the coming weeks. This means that any bad economic and financial news are more likely to negatively affect stock prices. This view is supported by the driver of the Macro (not shown), which has been moving horizontally for several months.  

Thus, our portfolios have been defensive, and are likely to remain defensive until the Micro and/or Macro MRI cycles turn to the uplegs of their cycles. Based on the trajectory of the Micro Driver in Figure 1, it looks like an upleg in the Micro MRI will be at least two weeks away. Accordingly, the next Plant season is a few weeks away.

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Notes

1.     Schwab Website

Quote from Schwab Company website https://www.aboutschwab.com/perspective-on-recent-industry-events. Extracted March 13, 2023.

·         “We believe one of the best indicators of the strength and stability of the firm is our client activity. Our February results show that clients entrusted Schwab with more than $41.7 billion in net new assets – our second-strongest February ever following our strongest January ever. Our growth and momentum have continued in March, with daily net new assets of over $2 billion per trading day month-to-date, including Thursday and Friday of last week. 

·         Following the recent events in the banking industry, we are pleased to see the U.S. Treasury Department, Federal Reserve, and FDIC step in with decisive action to support depositors during this critical time. We think the steps announced today provide an additional layer of protection for individuals and will help boost confidence in the American banking system.  

·         Collectively, more than 80% of client cash held at Schwab Bank is insured dollar-for-dollar by the FDIC. According to S&P Global Market Intelligence, that percentage is among the highest of the top 100 U.S. banks. As a comparison, the banks in the news the last few days have between 2% and 20% of their deposits insured.

·         As a further safeguard, Schwab has access to over $80 billion in borrowing capacity with the Federal Home Loan Bank (FHLB), which is an amount greater than all our uninsured deposits. That helps provide the firm significant access to liquidity, so money is there when clients need it. 

·         Investments at Schwab are held in investors’ names at the Broker Dealer. Those are separate and not comingled with assets at Schwab’s Bank.”

 

2.     Barron’s Article on Schwab Company Stock

Quote from Barron’s article https://www.barrons.com/articles/charles-schwab-stock-price-bank-selloff-4bb1ae5f). Extracted march 13, 2023. 

“Many banks and companies with related banking entities, such as Charles Schwab, also have a material amount of fixed income securities on their balance sheet with unrealized losses, as recently rising interest rates have decreased the value of fixed income securities,” Morningstar analyst Michael Wong wrote in a March 9 research note. He said he wasn’t concerned about Schwab’s liquidity or capital levels and doesn’t plan to change his $87 fair-value estimate. He says shares are undervalued.

Wong notes that Schwab had $36.6 billion of shareholders’ equity and a Tier 1 leverage ratio (a measure of core capital to total assets) of 7.2% at the end of 2022. That’s above the company’s internal target, and the regulatory minimum is 4%, Wong writes. 

Buying opportunity? Analysts Richard Repetto and Patrick Moley at investment bank Piper Sandler were quick to note the differences between Schwab and SVB, writing in a March 10 research report that “yesterday’s sell off is overdone and could present an attractive entry point into one of the strongest brands in financial services.”

 



1/11/2023

Weekly Note - January 11, 2023 - Update of Valuation Ratios and Corporate Earnings

 The note below covers:

1. Valuation Ratios for the DJIA are Still High
2. Corporate Earnings Have Not Yet Come Down

1. Valuations for the DJIA are Still High


Stepping outside the MRI framework, the valuations of the companies in the DJIA are still high compared to their valuations between January 2000 and last Friday (1/6/2022). Figure 1 below shows the current ratios and historical reference points. Please see this page for a brief description of these ratios.

Figure 1


The Price/Book (P/B) and Price/Sales (P/S) ratios are most important for this discussion. They are still high compared to the range of values since January 2000. As one can see in Figure 1, the percentile rankings of the current values are both above the 90th percentile. These figures mean stocks are expensive based on recent actual book values, sales, and earnings.  

In order for these high levels to be justified, corporate earnings growth will need to be strong going forward. In a time of slower economic growth induced by the Federal Reserve with higher interest rates, an outlook for especially strong economic growth does not seem to be the most likely scenario.  

Historically, these valuation ratios are low at market bottoms, and the ratios are shown for three recent market bottoms. DJIA prices will need to fall further to achieve those levels. In my elaboration of the industry adage “A Bull Market Climbs a Wall of Worry,” point #3 is relevant here – the current high valuation ratios suggest that stock prices will fall more than they already have.   

2. Corporate Earnings Have Not Yet Come Down


Figure 2 below shows the price of the DJIA (log scale, brown line), with the Peak-Earnings Indicator (PEI) in yellow. Last Friday is at the far right. The current major decline of the DJIA, which began in December of 2021, is indicated by “D”. The PEI has signaled that corporate earnings have been abnormally high throughout much of 2022. While earnings for the companies in the DJIA (shown by the double blue line) have declined somewhat since the mid-2022, they not yet declined as much as they have after the prior declines A, B, and C. Note that the declines in actual earnings typically occur several months AFTER the PEI has itself peaked.  

Figure 2




If historical patterns hold true, corporate earnings are likely to continue to decline further from here. If you would like to read my discussion of the PEI, I describe it here.

Based on the PEI and this analysis, the effects of a recession have not yet been seen in corporate earnings. Corporate earnings are likely buoyed by the ample Covid stimulus still in the system. That stimulus is helping to drive inflation, and the Fed is trying to dampen the effects of that stimulus. Thus, the economic battle between inflation and recession continues.


11/30/2022

Weekly Note - November 30, 2022

The note below covers:

1. Market Comment
2. Current Valuation Ratios
3. Conclusion
Note 1: Corporate Earnings Have Not Yet Come Down

1. Market Comment


The short-term cycle of resilience (measured by the Micro MRI) for the DJIA was at the 82nd percentile of levels since 1918 as of last Friday, which is a high level. The computer models and historical precedents continue to indicate that the recent move higher in the stock market is likely to be temporary and stock prices (as tracked by the DJIA) will be more vulnerable to declines when the Micro MRI moves to the downleg of its cycle. Please see this page for the language used to describe the MRI cycles: https://focused15investing.com/language

The Macro MRI, which indicates the longer-term trend of the stock market, is becoming less negative. In addition, the Exceptional Macro is very close to appearing for several stock market and bond market indexes. If these do indeed change, they would indicate a bullish view of the stock market (stock prices continuing higher) that could last several quarters or longer. As this shift takes place, we must recognize that the low point of this market decline might have already taken place at the end of September (when the Micro MRI began its upleg). At that time, there was little indication that these positive shifts might take place soon.

Nonetheless, the computer models and algorithms indicate that stock prices (as measured by the DJIA) are likely to be more vulnerable to declines over the coming weeks when the Micro MRI inevitably moves to the downleg of its cycle. Thus, our portfolios are still defensive. Qualitatively, I believe there will be a better time in the future for our portfolios to be aggressive. This view is supported by the high valuation ratios of stocks.

2. Valuations for the DJIA are Still High


Stepping outside the MRI framework, the valuations of the companies in the DJIA are still high compared to their valuations between January 2000 and last Friday (11/25/2022). Figure 1 below shows the current ratios and historical reference points. Please see this page for a brief description of these ratios.

Figure 1


The Price/Book (P/B) and Price/Sales (P/S) ratios are most important for this discussion. They are still high compared to the range of values since January 2000. As one can see in Figure 1, the percentile rankings of the current values are both at the 93rd level in this time period. These are high figures meaning stocks are not cheap based on recent actual book values, sales, and earnings.  These figures say stocks are expensive.

In order for these high levels to be justified, corporate earnings growth will need to be strong going forward. In a time of slower economic growth induced by the Federal Reserve with higher interest rates, an outlook for especially strong economic growth does not seem to be the most likely scenario.  

Historically, these valuation ratios are low at market bottoms - closer to their average valuation ratios indicated above (their 50th percentile rankings). DJIA prices will need to fall further to achieve those levels. In my elaboration of the industry adage “A Bull Market Climbs a Wall of Worry,” point #3 is relevant here – the current high valuation ratios suggest that stock prices will fall more than they already have. While not shown, the P/B and P/S ratios for the S&P 500 stock index are also high rating at the 85th and 92nd percentiles, respectively.  

3. Conclusion

The markets have been transitioning over the last several weeks and I expect them to continue to do so for the next few weeks. The markets are undergoing a shift from investor concerns being focused on inflation and high interest rates to a concern about recession and high valuations. However, instead of the market moving straight from a) inflation fear, to b) recession/valuation fear, the market seems to be going through an intermediate step: a) inflation fear, to b) everything will be OK (soft landing), to c) recession/valuation fears. A soft landing means that the Fed slows economic growth to curb inflation but does not push the economy into recession. Historically, soft landings have been difficult to achieve.  

Currently high valuation ratios support the potential dominance of c) recession/valuation fears.  Yet, the MRI are starting to signal an “OK-soft landing” for now. We had a similar situation in the early 2000s, and there was a further decline after a “OK-soft-landing” period of a few months, which the MRI identified. This view is supported by the Peak-Earnings Indicator analysis described in note 1 below. As the transition becomes clearer, we will move either way – becoming more or less aggressive. 


Note 1: Corporate Earnings Have Not Yet Come Down


Figure 2 below shows the price of the DJIA (log scale, brown line), with the Peak-Earnings Indicator (PEI) in yellow. Last Friday is at the far right. The current decline of the DJIA, which began in December of 2021, is indicated by “D”. The PEI signaled that corporate earnings are abnormally high throughout much of 2022, but earnings for the companies in the DJIA (shown by the double blue line) have not yet declined as far as they have after the prior declines A, B, and C.

Figure 2



If historical patterns hold true, corporate earnings are likely to continue to decline further from here. You can also see that the declines in earnings take place several months after the PEI has peaked. If you would like to read my discussion of the PEI, I describe it here.

Based on the PEI and this analysis, the effects of a recession have not yet been seen in corporate earnings. Corporate earnings are likely buoyed by the ample Covid stimulus still in the system. That stimulus is helping to drive inflation, and the Fed is trying to dampen the effects of that stimulus. Thus, the economic battle between inflation and recession continues and we appear to be lull between the two extremes.


10/26/2022

Weekly Note - October 26, 2022

The note below covers:

  1. Market Comment
  2. New Page – Repeated from Last Week’s Note
  3. Performance

1. Market Comment


As expected, the stock market has moved higher since the end of September. The move higher is likely a counter-trend rally, which is when prices move higher temporarily and then fall to a lower level than when the rally began.

As you may recall, the timing of this move higher is not a surprise; it is consistent with the projected movements of the Micro MRI. Since the beginning of 2022, the Micro MRI has generally followed its projected path. If the DJIA continues to follow the projected path, the current counter-trend rally will end in early November. Stock prices are then likely to be less resilient through the end of this year.

In addition to the projections calling for further price declines in a few weeks, the computer models and algorithms based on the MRI also are very cautious about the mid-term outlook for stocks. The following points describe the MRI conditions for the DJIA as of 10/21/2022. Please see this link for a discussion of our terminology: https://focused15investing.com/language

  • The Macro MRI has been in the downleg of its cycle since mid-December 2021, when it peaked at about the 80th percentile. The downleg continues and shows no sign of ending. A shift to the upleg of the Macro MRI cycle will be a strong indicator of the end of the current bear market.
  • The Macro MRI has declined to a low level. It is at the 32nd percentile of levels since 1918. The decline of the Macro from its recent peak at the 80th percentile to the current 32nd percentile has been quite steep. While I do expect it to decline further, we are coming closer to the inevitable end of the decline.
  • The Micro MRI is at the 26th percentile and in the upleg of its cycle. As mentioned above, the most likely path indicated by the projections is for it to move higher through early November and then begin another downleg that will be in place since through the end of the year.

Valuations for the DJIA are Still High


Stepping outside the MRI framework, the valuations of the companies in the DJIA are still high compared to their valuations between January 2000 and last Friday. Figure 1 below shows the current ratios and historical reference points. Please see this page for a brief description of these ratios.

Figure 1


The Price/Book (P/B) and Price/Sales (P/S) ratios are most important for this discussion. They are still high compared to the range of values since January 2000. The percentile rankings of the current values are 85th and 87th, respectively. In a time of slower economic growth and higher interest rates, I expect these valuation ratios to drop to levels close to or below their average valuation ratios indicated above (their 50th percentile rankings). DJIA prices will need to fall further to achieve those levels. In my elaboration of the industry adage “A Bull Market Climbs a Wall of Worry,” point #3 is relevant here – the current high valuation ratios suggest that stock prices will fall more than they already have.

This relatively low P/E ratio is noteworthy. When P/B and P/S ratios are high and the P/E ratio is relatively low, we can infer that the market, in its collective wisdom, is indicating that the current level of corporate earnings is abnormally high and is likely to decline. 

Figure 2 below shows the price of the DJIA (log scale, brown line), with the Peak-Earnings Indicator (PEI) in yellow. Last Friday is at the far right. The current decline, which began in December of 2021, is indicated by “D”. As you can see the PEI is still high compared to the PEI before the Global Financial Crisis (A) and the Covid Crash of 2020 (C).

Figure 2


The double blue line in Figure 2 above indicates actual earnings of the DJIA companies. At the far right of the line, we can see that earnings level has declined from its peaks at the end of 2021. But we can also see that the decline in earnings has been less than the declines that occurred after the high PEI readings at points A and C, despite the indicator being at a similarly high level. 

The recent decline in earnings thus far is even less than decline taking place after B, even though the PEI is currently quite a bit higher now (D) compared to B. If historical patterns hold true, corporate earnings are likely to continue to decline further from here. If you would like to read my discussion of the PEI, I describe it here.

Thus, with the Macro MRI indicating a lack of resilience, high P/B and P/S valuation ratios, and the PEI still signaling abnormally high earnings and lower future earnings, the most likely path for stocks as tracked by the DJIA is for further stock price declines than we have seen thus far in 2022. Other stock indexes have similar MRI conditions, with the exception of the tech-heavy NASDAQ, which is a little further along the downleg of its Macro cycle. It is perhaps closer to the inevitable inflection point indicating the end of its bear market.

Bonds Likely to Become More Attractive


As the country moves into an economic recession, the Fed will be more inclined to slow interest rate increases and perhaps even induce lower rates. These moves may make our bond ETFs more resilient. I suspect that decreasing our Box #2 Cash levels and increasing the bond allocations will be one of next major moves. However, as of today, the timing is not right for this change.

2. New Page – Repeated from Last Week’s Note


On page 2 of the weekly report, I show the target weights for all model portfolios. There is no new information on page 2. This page simply pulls together information stated on other pages, which still exist. My goal is to simplify your task of locating the target weights you need to use.

If you have selected the portfolio indicated as “Main” as your long-term portfolio, the orange box indicates the portfolio that you should be using at this time. The portfolio in the orange box is one step less aggressive than the Main portfolio, as specified in the note, “Box #3 Portfolio Shift Relative to Your Long-term Portfolio: -1.”

If you are using for your long-term portfolio one other than the Main portfolio, use the next less aggressive portfolio to implement the Box #3 Portfolio Shift: -1.

3. Performance (not audited)


Below are estimates of the returns that one would get from December 31, 2021 through last Friday by following the instructions for the “main” portfolios for each of the publications. Please see endnote for a brief comment on the main portfolios. Contact me with questions.

The year-to-date returns as of 10/21/2022 are:

   Diamond:    -8.6%
   Sapphire:    -10.7%

These returns compare favorably to the following alternatives:

   DJIA:         -13.4%
   S&P500:     -20.3%
   NASDAQ:    -30.1%
   IEF:            -18.0% ETF for the US 7-10-year Treasury bond index, with no leverage

   VBINX:     -19.5% Vanguard Fund with 60% of assets in stocks and 40% in bonds
   VASGX:    -21.5% Vanguard Fund with 80% of assets in stocks and 20% in bonds

Endnote: Main Portfolios

The main portfolio in the Diamond publication is sg235, and the main portfolio in the Sapphire publication is sg325. If you use either of these as your long-term portfolio and have followed the instructions since the first of the year by switching to the target weights of a less aggressive portfolio (by following the specification for Box #3, i.e., “-1”) and holding Box #2 Cash as instructed, your account’s performance should be close to the figures above.

Some deviation between your account and the numbers above can be expected. The performance figures above assume trading is done at the close of trading (4 pm, Eastern) on Fridays. Most people trade earlier in the day. In addition, we sometimes trade before Friday.

If you use as your long-term portfolio one that is more aggressive or less aggressive than the “Main” portfolio, your actual performance will be different.

The figures above are based on the actual ETFs in the model portfolio. The figures in the weekly publication are based on the index that the ETFs track.

8/23/2022

Weekly Note - August 24, 2022

We are still in a Wait season. The next potential Plant season is likely to be in late September.

The Comments section below (not required reading) covers:
1. Current Market Conditions
2. Market Resilience Index (MRI) Conditions
3. Recent Performance

Links included in the text below:

Current Stock Valuations: https://marketresilience.blogspot.com/p/djia-historical-valuation-comparison.html

Historical Inflationary Periods: https://marketresilience.blogspot.com/p/inflationary-periods.html

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

1. Current Market Conditions (Updated 8/23/2022)


Based on the MRI of a wide range of asset classes (e.g., stocks, bonds, commodities), longer-term investor concerns are shifting away from high inflation toward a possible economic contraction - concern about inflation is still high but is fading. 

At this time, I see DJIA’s recent move higher as the last portion of a counter-trend rally that began in mid-June. The MRI support this view and suggest that stock prices will soon weaken. Many stock indexes have Micro MRI that are very high in their cycles and are shifting to the downlegs of their cycles. I list these and other indexes with their MRI statistics in section 2 below.

Recent business articles have statements similar to this Bloomberg headline of 8/16/2022: “JPMorgan Says the Stock Rally Has Legs. Morgan Stanley Disagrees.” Current MRI dynamics and valuation metrics (mentioned below) support the Morgan Stanley opinion described below. An excerpt from the Bloomberg article:

Top Wall Street strategists are divided on whether the US stock market is poised to extend its longest winning streak of the year -- or slip back after another false dawn.

Morgan Stanley strategists said in a note Monday that the sharp rally since June is just a pause in the bear market, predicting that share prices will slide in the second half of the year as profits weaken, interest rates keep rising and the economy slows. But rivals at JPMorgan Chase & Co. said the rally -- which has pushed up the tech-heavy Nasdaq 100 index by over 20% -- could run through the end of the year.

The schism reflects the highly uncertain outlook for the US stock market in the face of strong cross-currents. On the one hand, inflation is showing signs of pulling back from its peak and businesses have been expanding payrolls at a strong pace, both of which auger well for equities. Yet at the same time, Fed officials have signaled that they will continue to raise interest rates aggressively until consumer price increases are reined in, which risks driving the economy into a recession.

My analysis of valuation ratios for the DJIA supports the more pessimistic view held by Morgan Stanley. The valuation measures of Price/Sales and Price/Book are high by historical standards, and the market is also signaling that we may be in a period of peak earnings; earnings are likely to decline in the coming months. High valuations and potentially declining corporate earnings do not bode well for the stock market, and this is especially true when interest rates are rising. Valuation is not a formal part of our process because of data limitations. Instead, I use it for market context. I have updated an analysis done earlier this year here: https://marketresilience.blogspot.com/p/djia-historical-valuation-comparison.html

While concerns for high inflation and interest rate hikes are receding (for the time being), it is too soon to assume inflation has been tamed. There is a broad range of experiences with inflation over the last 100 years. The most recent period of high inflation was during the 1960s and 1970s, when high inflation persisted for about 18 years. This is probably an extreme case in terms of length. The inflationary period after World War 1 and Spanish Flu pandemic ended abruptly. Other periods of inflation fall in between these.

For historical context, I have added a post, “A Historical Perspective on Past Inflationary Periods,” which shows periods of inflation over the last 100+ years and how the DJIA has performed. It also shows how the MRI-based algorithms we use in the model portfolios performed over different periods. https://marketresilience.blogspot.com/p/inflationary-periods.html

Note about Drivers of Resilience: The MRI drivers I have discussed recently are beginning to indicate a turning point in the Macro MRI, potentially causing it to be less negative. Historically, following the actual Macro MRI has been more successful than following its drivers. However, the drivers give us a view into what may happen in the more distant future. Also, we continue to be in a period of "low investor excitability." During such periods, rapid price changes, either higher or lower, are less likely. 

2. Market Resilience Index (MRI) Conditions


See this link for a description of the language used to discuss resilience: https://focused15investing.com/language.

The DJIA is transitioning to a more vulnerable condition. Last Friday's level of DJIA's Micro MRI moved lower from the prior week; it appears to have begun the downleg of its cycle. Neither the Macro nor Exceptional Macro MRI for the DJIA are providing resilience. These conditions describe a counter-trend rally that is likely to end soon, which means that stock prices are likely to resume the longer-term trend downward established earlier in the year. 

Other US stock indexes are in similar conditions, which reinforces the view that we have indeed been in a broad-based counter-trend rally. All have Micro MRIs at the upper ends of their ranges that are shifting to the downlegs of their cycles. None have longer-term measures of resilience (Macro Exceptional Macro) in the uplegs of their cycles, which makes them vulnerable to declines when their Micro MRIs inevitably make a shift to their downlegs.

Section Updated as of 8/19/2022  
  • DJIA: percentile 82, 83 the prior week. Levels since 1918
  • S&P 500: 92, 93 the prior week. Levels since 1931
  • NASDAQ: 78, 78 the prior week. Levels since 1972
  • Russell 2000: 88, 90 the prior week. Levels since 1985 (small company stocks)
The same is true for these indexes or assets (don’t worry if these terms are not familiar; some people may find these useful):
  • DJ Transports: 81, 81 the prior week. Levels since 1916
  • NASDAQ vs DJIA: 79, 81 the prior week. Levels since 1995
  • Russell 2K vs DJIA: 92, 95 the prior week. Levels since 1995
  • R1K Growth vs Value:  91, 95 the prior week. Levels since 1985 
  • MSCI US Sectors: Cyclical vs Defensive: 92, 94 the prior week. Levels since 1995

Indexes with Micro MRIs moving opposite to those mentioned above:
  • VIX: 6, 2  the prior week. Levels since 1998
  • Credit Spreads: 12, 10 the prior week. Levels since 2002 (Macro MRI is positive)
All the indexes above have Micro MRI at extreme levels, which are likely to revert toward their means in the next few weeks.

3. Performance (not audited)


The US stock market has declined from December 31, 2021 through last Friday. I have calculated the returns that one would get by following instructions since the beginning of the year for the “main” portfolios for each of the publications. Please see endnote for a brief comment on the main portfolios. Contact me with questions.

The year-to-date returns as of 8/19/2022 are:

Diamond: -3.3%
Sapphire: -5.6%

These returns compare favorably to the following alternatives:

DJIA: -6.0%
S&P500: -10.4%
NASDAQ: -18.4%
IEF: -10.1% ETF for the US 7-10-year Treasury bond index, with no leverage

VBINX: -10.9% Vanguard Fund with 60% of assets in stocks and 40% in bonds
VASGX: -12.5% Vanguard Fund with 80% of assets in stocks and 20% in bonds

Endnote: Main Portfolios

The main portfolio in the Diamond publication is sg235. The main portfolio in the Sapphire publication is sg325.

If you use either of these as your long-term portfolio and have followed the instructions since the first of the year by switching to the target weights of a less aggressive portfolio (by following the specification for Box #3, i.e., “-1”) and holding Box #2 Cash as instructed, your account’s performance should be close to the figure above.

Some deviation between your account and the numbers above can be expected. The performance figures above assume trading is done at the close of trading on Fridays. Most people trade earlier in the day. In addition, we sometimes trade before Friday. If you use as your long-term portfolio one that is more or less aggressive than the main portfolio, your actual performance will be different.

The figures above are based on the actual ETFs in the model portfolio. The figures in the weekly publication are based on the index that the ETFs track.

6/22/2022

Weekly Note - June 22, 2022

 The MRI suggest the end of the current stock price decline is several weeks away.

This post describes the current level of the DJIA from two perspectives. First, I compare this decline to other major price declines over the last 100+ years. If these past declines are a relevant guide, the depth of the current decline is as severe as the others considered. 

Second, the DJIA’s current valuation measures (Price/Book and Price/Sales) compared to the period from 1993 to the present suggests that prices need to fall further to approach low valuation levels that have been attractive historically. From this perspective as well, the current decline appears to be several weeks away from the end. 

For the last 20+ years, the Fed has stepped in to support economic growth by lowering interest rates when the stock market weakens and the economy begins to falter. However, the Fed is far less likely to lower interest rates in this situation because doing so would, at this time, encourage inflation and fighting inflation is currently the Fed’s primary objective. The MRI don’t tell us if the economy will slip into recession. They indicate market resilience and vulnerability. At this time, the stock market looks very vulnerable to declines. 

The Current Stock Market Decline Compared with Others Over the Past 100+ Years

As of last Friday, we are at week 24 since prices peaked in early January of this year. Compared to major declines over the last 100+ years, the current decline is more severe than prior declines, many of which went on to experience even deeper declines before moving higher. 

Earlier this year, I wrote that 2022 may be similar to the DJIA decline that began in 2000. The collapse of the Dotcom bubble beginning in 2000 most directly affected the NASDAQ stock index, which is biased toward tech stocks. But the collapse also affected the DJIA. The DJIA made a long slow decline from 2000 to 2002 and then dropped again in 2003. During that period the Onyx sleeve consisting of the ETFs XLP (consumer staples stocks), XLU (utilities stocks), and UST (7-10-year Treasury Bonds), and SHY (1-3-year Treasury bonds) performed well.

However, over the last few months, we have seen stronger-than-expected declines in the Onyx sleeve ETFs. Thus, the decline that began in 2000 is not a useful guide for this decline. The broad nature of this decline suggests it could continue for several weeks more. 

Figure One below shows price performance of the DJIA for several declines since 1929, including those beginning after prices peaked on:

  • 1.       9/6/1929
  • 2.       5/3/1937
  • 3.       11/3/1939
  • 4.       1/5/1973
  • 5.       5/29/1981
  • 6.       1/21/2000
  • 7.       10/12/2007
  • 8.       2/14/2020
  • 9.       1/7/2022 - the current decline

The horizontal axis is the number of weeks after the DJIA peaked. The line descends to the lowest point in that decline and is then horizonal from that point until it reaches the scale on the right. All lines start with the value of 1.0. A decline ending at 0.60 on the scale, for example, means a 40% loss of the starting value. The thick green line is the current decline.

Figure One – Nine Major Price Declines Since Early 1929



 


The line shown by “A” is the decline beginning in 1929. The DJIA declined over a period of 148 weeks, to 7/1/1932, to a value of about 0.13, or 13% of its original value (scale on the right), which means that the DJIA lost about 87% of its value during that decline, definitely a startling loss. 

The line by “B” is the decline that began after the peak in prices on 2/14/2020 and relates to the COVID crash. This decline was even steeper than the early weeks of the 1929 decline. The DJIA took only five weeks to reach the bottom of the 2020 decline. It declined to 65% (scale on right) of the value it had on 2/14/2020, representing a loss of 35%. 

Figure One presents a reasonable comparison for the current decline (shown with the thick green line) showing the depth and duration of major declines since early 1929. Against this backdrop, the current decline has a relatively short duration, which is consistent with the MRI conditions indicating that the bottom of the market is several weeks away. When the bottom of the market does arrive, the DJIA will likely be at a lower level than it is now. 

Excluding the decline starting in 1929, all other declines ended at values between roughly 0.45 and 0.80, representing losses of about 20% to 55%. The current decline for the DJIA, shown by the heavy green line, is just approaching that range with a roughly 17% decline so far. 

For clarity, Figure Two below is the same as Figure One but without the declines beginning in 1929 and 2020. The depth and duration of the 1929 decline should be kept in the back of our minds but we are not likely to have a decline of its scale in the near-term. Policy makers made several mistakes during the 1929 decline, which I referenced in an earlier note. 

The 2020 decline is not applicable to the current decline because it was ended by extraordinary stimulus around the world. Stimulus of that scale seems less likely to occur for this decline because there is recognition that the stimulus implemented to address the 2020 decline may have magnified the inflation challenge we now face, and the Fed has indicated that it will aggressively fight inflation by increasing rates and reducing other measures supportive of the markets. See endnote #1.

Figure Two – Major Declines Excluding 1929 and 2020

The heavy green line in Figure Two (and Figure One) represents the current decline, after prices peaked 1/7/2022. As of last Friday (6/17/2022), we were at week 24 and the DJIA is at 0.83 of its beginning level, which means a 17% loss.  The other declines shown in Figure Two had an average loss of 9% by week 24.  Thus, the current decline is comparatively steep. 

The orange line by “C” is shows the path of the decline that began in 2000, after the Dotcom bubble. Especially over the last few weeks, the market has experienced sharper losses than the 2000 decline. It is no longer reasonable to compare the current decline to the 2000 decline. 

Of the declines shown, the average total decline was 39%, and this may be a reference point to consider for the magnitude of decline that may transpire for the current decline. This is not a forecast, but simply an observation to help frame expectations. 

Valuations Suggest that Prices are Not Yet Low

Figure Three below shows the price of the DJIA (brown, log scale, right) since 1993, along with the Price/Book (purple) and Price/Sales (blue) ratios. Valuation data for earlier dates is not available through my data sources. The current readings are at the far right of the figure. 

All else equal, lower valuation ratios are more attractive for purchasing stocks. After a period of price declines on investor concerns about the future, unusually low valuation ratios entice investors to buy even when the future is questionable. We can see from prior declines the valuation ratios that enticed investors to buy.

The ellipses show the levels of these ratios at the bottom of the major declines of the period from 1993 to the present. In all cases, the current ratios are higher than the levels at the ends of prior declines, suggesting that the current ratios may need to decline further to attract investors. The current level of the Price/Book ratio (purple, left scale) is 4.0. This means that the current price of all companies in the DJIA is four times the sales of all those companies. The average Price/Book value for this entire period is 3.3. The value of this ratio at the bottoms of the prior declines indicated is 3.0 or lower. Thus, the current value is still high by these historical standards. 

The Price/Sales ratio (blue, also on left scale) is currently 2.1, meaning that the price of the DJIA companies is just over twice the sales of those companies. The average Price/Sales value for this entire period is 1.4. For the end of the 2000 decline in 2022, the Price/Sales ratio was about 1.0.  In 2009, it was 0.6. In 2020, the lowest value was 1.4. Thus, the current value is still high by these historical standards. 

The high valuation ratios of the last few years have been more acceptable to investors because interest rates have been low. Low interest rates tend to boost economic growth, and high economic growth justifies high valuation ratios, all else equal. Low interest rates also give the long-term future growth of book value and sales a greater weight in determining the current fair value of a company. But when interest rates move rapidly higher, strong future economic growth is called into question and any growth that does occur in the distant future has less weight in determining current fair price of stocks.  Thus, a sharp move higher in interest rates has these two important effects. 

These forces can cause investors to care much more about the near-term prospects of a company.  Companies with weak near-term earnings but promises of high future growth can be shunned by investors because the rosy future may not materialize as expected. Therefore, indexes that are heavily weighted to companies promising high future growth, like the NASDAQ stock index, can become relatively more vulnerable to price declines. We are seeing this in the performance numbers reported below – the NASDAQ has had greater losses this year than the DJIA. 

While the above material describes the context of the current market, our portfolios are influenced more by the MRI. The MRI indicate that the stock market will continue to be vulnerable to declines for several more weeks. 

Performance

The US stock market has declined from December 31, 2021 through last Friday. I have calculated the returns that one would get by following instructions since the beginning of the year for the “main” portfolios for each of the publications. Please see endnote #2 for a brief comment on the main portfolios. Contact me with questions. 

The year-to-date returns as of 6/17/2022 are:

   Diamond:    -6.3%
   Sapphire:   -8.5%

These returns compare favorably to the following alternatives:
   DJIA:       -16.9%
   S&P500:     -22.3%
   NASDAQ:     -30.7%
   IEF:        -12.4%   ETF for the US 7-10-year Treasury bond index, with no leverage

   VBINX:      -18.9%   Vanguard Fund with 60% of assets in stocks and 40% in bonds
   VASGX:      -19.8%   Vanguard Fund with 80% of assets in stocks and 20% in bonds


end

_________________________________________________________

Endnotes

1 - Well before COVID, we had an extended period of exceptionally low interest rates.  During that period, policy makers around the world tried to get inflation to move higher. The Fed wanted to get inflation up to 2% and was struggling to induce inflation by keeping interest rates exceptionally low. During this period, the prices of many assets went higher. Stocks, bonds, real estate, cryptocurrencies, etc. rose in price. Then COVID came along, and the government added even more stimulus to keep the economy from falling further than it otherwise would. 

Inflation has gone higher – much higher - than policy makers expected.  In response, the government support is being retracted.  Most notably, the Fed is pushing interest rates higher. As rates go higher, all the assets that seemed reasonably priced two years ago are seeming more expensive. Stocks, bonds, real estate, cryptocurrencies, etc. are now moving lower. 

The MRI started to indicate greater market vulnerability in the middle of 2021. From this perspective, a good portion of what we are experiencing was already in motion at that time. The war in Ukraine and the resulting boost in energy prices has added to inflationary pressures but does not appear to be the sole cause of the inflation we are experiencing. The MRI indicate that forces over many years contribute to the current conditions. From this perspective, addressing the weaknesses in the stock market and probably the economy will be a long-term effort. This further supports the view emanating from the MRI that we have several weeks to go before the decline ends. 

2 - Main Portfolios

The main portfolio in the Diamond publication is sg235. The main portfolio in the Sapphire publication is sg325.

If you use either of these as your long-term portfolio and have followed the instructions since the first of the year by switching to the target weights of a less aggressive portfolio (by following the specification for Box #3, i.e., “-1”) and holding Box #2 Cash as instructed, your account’s performance should be close to the figure above. 

Some deviation between your account and the numbers above can be expected. The performance figures above assume trading is done at the close of trading on Fridays.  Most people trade earlier in the day. In addition, we sometimes trade before Friday. If you use as your long-term portfolio one that is more or less aggressive than the main portfolio, your actual performance will be different. 

The figures above are based on the actual ETFs in the model portfolio. The figures in the weekly publication are based on the index that the ETFs track.