Archive for March, 2016

Bloomberg Declared Emerging Markets In Bull Status — Maybe That’s Just Bull

Saturday, March 19th, 2016

(this is our letter to clients 2016-03-18)

QVM Clients,

Today, a Bloomberg TV announcer said emerging markets are now in a Bull phase. Don’t get overly excited by that call. I know why they said that, but question the utility of their definition.

Vanguard’s emerging markets ETF, for example, closed at $34,40, up 11.2% from is multi-year closing low of $30.74; and up 22.9% from its multi-year low intra-day price. The former is not a Bull, and the latter, even if that is a reasonable way to measure, is not a Bull in the overall price history of the ETF.

It is well accepted that a 20% decline from a high is a Bear; but it is less well accepted that a 20% rise from a bottom is a Bull. However, let’s consider some hypothetical extremes first.

Let’s say a $100 stock grinds down to $10 within 12-months or less. If that stock rose to $12 (up 20%), Bloomberg would have to call that a Bull, even though it was 88% below its high.

That contrasts greatly to a $100 stock that declines to $80 (the Bear threshold) and then climbs to $96 (a 20% rise). Maybe that is a Bull.

Some other qualitative factor needs to be present, in my view, to call a Bull after a Bear.

That, to me, involves at a minimum bringing the trend line into the picture, if not the relationship of the price to the trend line.

If that $100 stock that went to $10 and stayed there for a year, and then went to $12 – now maybe that is a Bull – because by then the trend line would be in the vicinity of $10 and the rise to $12 becomes more meaningful.

So now let’s look at Vanguard’s emerging markets ETF to see if a Bull is realistic.

Here is simple monthly chart (where the last price bar is month-to-date) over many years. Visually, without any technical aids, it is hard to think of the March price action as a return to Bull status.

(click images to enlarge)


Here is 14 month chart. OK, maybe the last price bar looks like a big improvement, because it is above the trend of the closes, as you can visualize without aids.


Now let’s look at it through the lens of some technical filters. Without even explaining all the extra plots on the chart, it starts to look a lot less appetizing, and not so Bullish.


Emerging markets may pose a trading opportunity, perhaps the recent rise will continue and become what we would accept as a Bull, but for now it is at best a counter-trend rally in a downward market. And, none of that considers the terrible constitutional crisis and economic problems in Brazil, or the sanctions against Russia, or the challenges in China to get past their real estate bubble and extend-and-pretend their bank loan portfolios, or the continual capital flight from those nations.

Let’s consider this last chart and see how it tells us emerging markets are not in a Bull state.

The top panel is our net market condition and phased tactical allocation modulation rating, on a scale from 0 to 100, based on four factors:

  • The direction of the primary trend line (the gold line)
  • The price relative to the trend line
  • The changes in price relative to volume – supply/demand (dashed green line versus 50 level on left scale)
  • The price relative to a time based performance test (price vs dotted red line)

We give half of the weight to the direction of the trend line, and one sixth of the weight to each of the other three factors, to arrive at the overall market condition rating shown in bold black in the upper panel.

You can see that:

  • The trend direction is down (Bearish)
  • The price is below the trend line (Bearish)
  • The demand/supply ratio is under 50 (Bearish)
  • The price is below the time & performance threshold (Bearish)

Buying into emerging markets at this point is a speculative approach. Not wrong, but speculative; and should not be done on the basis of an off the top of the head TV declaration of a Bull without a more in-depth look at the total price behavior picture.

A lower risk way to enter emerging markets or any other market is to do it in stages. One way to move in stages would be to modulate exposure to each risk category based on a variable indicator of the trend strength of each category. We posit that our 4 factor tool is one reasonable tool for guiding a staged shift of allocation within a category, relative to your long-term policy allocation for each category.

In closing, here are the market condition ratings using the same tool for the leading S&P 500 ETF, its 9 sector ETFs; the soon to be declared 11th sector ETF (for real estate equities) and the stock ETFs for the world excluding the US, emerging markets, and China (the largest component county weight within the emerging markets index):

  •    17 – S&P 500 (SPY)
  •    17 – Materials (XLB)
  •     0 – Energy (XLE)
  •     0 – Financials (XLF)
  •   80 – Industrials (XLI)
  • 100 – Technology (XLK)
  • 100 – Consumer Staples (XLP)
  • 100 – Utilities (XLU)
  •    17 – Health Care (XLV)
  • 100 – Consumer Cyclicals (XLY)
  •   80 – Equity REITS (VNQ)
  •      0 – World excluding US (VEU)
  •      0 – Emerging Markets (VWO)
  •      0 – China (GXC)

These are trend following ratings, not based on any other technical parameter. They are not fundamental ratings or valuation ratings or thematic ratings. These are purely and simply statements of the status of the trend at this time. To the extent that most of the time (but not all of the time) the near-term future resembles the short-term past, these trend ratings may be predictive. However, they do not make suggestions about long periods of time. They are tactical ratings for allocation shifting within and around long-term policy allocation levels for each asset category.

For example, when you look at the S&P 500 and its sector ETFs through a valuation filter using the PEG ratio (P/E ratio divided by estimated 5-year earnings growth rate), as a measure of GARP (growth at a reasonable price), you get a different picture (where lower is better, and more than 2 is expensive):

  • 1.98 – S&P 500 (SPY)
  • 3.18 – Materials (XLB)
  • NMF – Energy (XLE)
  • 1.68 – Financials (XLF)
  • 1.64 – Industrials (XLI)
  • 1.37 – Technology (XLK)
  • 2.53 – Consumer Staples (XLP)
  • 3.86 – Utilities (XLU)
  • 1.97 – Health Care (XLV)
  • 1.20 – Consumer Cyclicals (XLY)

If you consider trend status and the cost of growth together, Industrials, Technology, and Consumer Cyclicals look like the best current bets. We will likely add exposure in these areas.   Utilities and Telecom (not available in an S&P 500 sector ETF) are both expensive in PEG terms, but are trending nicely. As yield oriented sectors, they are expected to suffer when interest rates rise.

Investors can make other arguments for other sectors based on fundamental, valuation or themes. For example, Energy pops out as a recovery story when oil prices i; and Financials are expected to do well when interest rates begin to rise.

We will look at and write to you about some related breadth data and valuation data for US indexes, sectors and industries in the next several days.

In the meantime, don’t take TV host analysis of emerging markets as in a Bull market totally on board, without considering the information in this note.

Still Bearish, Rally Notwithstanding

Monday, March 14th, 2016

[this is the content of our letter to clients today]

Discussed in this letter:

  • How market condition rating can be used in allocation shifting
  • 4 Factor allocation shifting indicator with current readings
  • % US broad market stocks in Correction, Bear or Severe Bear condition
  • Relative performance of smaller-cap indexes vs larger-cap indexes as simple breadth indicators
  • % S&P 500 index stocks and of sector stocks above their 200-day trend line
  • 2016 and 2017 S&P 500 and sectors revenue and operating earnings forecasts
  • Historical reported S&P 500 earnings and price (with earnings and dividend yield vs Treasury yield)
  • Treasury yield curve
  • Junk bond yield spread to comparable maturity Treasuries
  • Federal Reserve financial system stress indexes versus total stock market index price
  • Bull/Bear ratio charts from Investors Intelligence and American Association of Individual Investors
  • Net flow of funds within S&P 1500 stocks
  • Compare flow of funds to stocks between corporate buybacks and investment funds
  • 1-year relative performance of key asset categories within stocks, bonds and commodities
  • Our net current Bullish or Bearish view


What use is close monitoring of stock market condition?

For an investor who is determined to hold a static portfolio through good times and bad, the answer is not very much.

For a young people executing a regular weekly or monthly investment accumulation program with many years ahead, bad news is good news, because they purchase more shares per Dollar of investment when the market is down than when it is up. In the long-term market downturns help them accumulate wealth. So they can ignore all this, unless they want to increase their periodic investments during market downturns.

For investors in retirement who are not overfunded and who must sell assets for their standard of living, it is important to be aware or stock market conditions to decide which assets to sell to minimize the risk of rapid portfolio depletion, or to know when to minimize withdrawals to the extent possible.

Then for others who wish to tactically modulate their asset allocation in response to and to potentially profit from changing stock market conditions, this stuff is very important. For those of our clients, this market condition information is useful.

For example, an investor with a long-term 50/50 stock/bond policy allocation, but with a collar around that policy level of say a more defensive 40/60 to a more aggressive 60/40 allocation, this information could be used to decide when and how to modulate. Let’s call that allocation shifting, where the allocation revolves around the target level based on market conditions.

It could apply to any target policy allocation with collars; such as an aggressive 80/20 stock/bond long-term target with a 70/30 to 90/10 range; or a 30/70 with a 20/80 to 40/60 range.

This first chart is our monthly “Allocation Shifting Indicator” (the bond black line in the top panel) which rates a market from 0 to 100 for condition where 0 is very weak and 100 very strong.

A hypothetical investor with a target policy 50/50 stock/bond allocation, and with 40/60 to 60/40 collars, might use the data this way:

When the indicator is at zero, a more defensive posture is suggested, which for that investor would be 40/60 stock/bond. At an indicator reading of 25, a less defensive posture of 45/55 might be appropriate. When the indicator is at 75, a more aggressive 55/45 stock/bond allocation is suggested by the indicator. Then when the indicator is at 100, the maximum risk level within that particular investors investment policy would be called for at 60/40 stock/bond.

The same logic would apply to any investment policy target allocation, and to any magnitude of more defensive and more aggressive range endpoints.


With all that said, let’s dive into the allocation shifting indicator.

With this indicator we focus on monthly data, which is not so volatile as weekly or daily data to avoid a lot of “whipsaw” risk — the indicator is not constantly switching back and forth between aggressive and defensive signals. We use four different criteria that are minimally overlapping in what they measure:

  1. TREND: the direction of the tip of a 10-month primary trend line (weight 4x)
  2. SUPPLY/DEMAND: based on volume weighted price changes (weight 3x)
  3. PRICE and TIME: a geometric time decay indicator that tightens the threshold of position profitability over time (weight 2x)
  4. PRICE vs TREND: the position of the price above or below the primary trend line (weight 1x)

You can see with this price chart for SPY (an investable S&P 500 proxy) spanning two major tops and two major bottoms (lower panel), that the indicator (bold black line in top panel) reached a zero reading in time to save a lot of pain and lost money in 2001 and 2008. It also did a decent job to suggesting a profitable re-entry (or increased risk allocation) with a 100 reading in mid-2003 and the end of 2010. You will also notice that as the indicator moved from zero to 100 (and from 100 to zero) it passed through intermediate levels that suggested phased reduction and increase in equity risk.

As of the end of February, the indicator suggested defensive positioning, with a reading of 10.

(click images to enlarge)


Here is a zoomed-in view of the monthly indicator. The middle panel with the blue plot line and red horizontal lines shows the percentage the price is off of its 12-month high, so you can compare that to the signals from the indicator. This month-end indicator did not predict the August 2015 Correction and basically followed the market down with reduced equity exposure as the market deteriorated. If the trend is actually down, however, it would have the investor positioned defensively.


The current monthly indicator readings for several key indexes are (month-end / week-end):

  • Russell 50 ultra-mega-cap (XLG) 70 /70
  • S&P 100 mega-cap (OEF): 70 / 30
  • S&P 500 large-cap (SPY): 10 /10
  • S&P 400 mid-cap (MDY): 0 / 0
  • S&P 600 small-cap (IJR): 0 / 0
  • Russell 2000 small-cap (IWM): 0 /0

You can see that it is the largest companies that are holding up the market, while the smaller company prices are struggling.

The current monthly indicators for the 9 S&P 500 sectors ETFs are:

  • Materials (XLB) 10 / 40
  • Energy (XLE) 0 / 0
  • Financials (XLF) 30 / 0
  • Industrials (XLI) 50 / 60
  • Technology, incl. Telecom (XLK) 100 / 70
  • Consumer Staples (XLP) 100 / 100
  • Utilities (XLU) 100 / 100
  • Health Care (XLV) 30 / 20
  • Consumer Cyclicals (XLY) 100 / 50

It is human nature to anticipate, so even though we think monthly data is best used most of the time, we cannot resist trying to peak around the corner to see what may be coming down the path in the current month by examining weekly data. So far, the weekly data for the S&P 500 has the same defensive suggestion with a reading of 10 for the indicator.

You can see that the weekly indicator did “sense” a problem and suggested a 75% risk level just before the August Correction, but it also got “whipsawed” a bit by the subsequent rally. At this point it is suggesting the current rally has not proved itself to be sustainable yet.




The allocation shifting indicator, which is at the index level, may not be sufficient to tell a full enough story. So let’s go inside the index and look at what its constituents are doing to help us interpret the market condition with perhaps more advance warning or notice of developing changes.

This chart plots the S&P 500 index and its 40-week average in black and dashed orange, and also the percentage of the S&P 1500 index constituents that are in a 10+% Correction or worse; a 20+% Bear market or worse; and a 30+% Severe Bear market or worse.


As you can see from the chart and the table of values below the chart, the great majority of constituent stocks are in pretty tough shape – more than 2/3 in Correction or worse, 40+% in a Bear market or worse; and 24% in a Severe Bear market or worse.

This chart also plots the S&P 500 in black and orange, but also the percentage of S&P 1500 constituent stocks within 2% of their trailing 1-year high. Before the August 2015 Correction about 1/3 of stocks were within 2% of their high, but now only about 12% That shows continuing thinning of the leadership.




A straight forward ratio of the performance of stock indexes can also show the weakness of the broad market.

This charts plots the ratio of the S&P 500 equal weight index (RSP) to the S&P 500 market-cap weighted index (SPY). The declining line shows that the lower average size constituent of RSP is underperforming the larger average size SPY. That is weakening market breadth.


More dramatically, this chart plots the ratio of the Russell 2000 index (IWM) to the Russell Top 50 stocks (XLG). The small-caps have been underperforming for many months now; showing that the largest stocks are driving the market while overall breadth is poor.




On the side of continued caution is this 10-year weekly chart, which plots the percentage of S&P 500 stocks that are above their 200-day moving average (60% at this point). That is better than less than ½, but still well below the 70+% levels that characterized the pre-August Bull phase.


The 9 S&P 500 Sector ETFs for the S&P 500 look like this in terms of the percentage of their constituents above their 200-day trend line:


Consumer Staples and Utilities are yield oriented sectors that are overbought in the scramble for yield. They are competitively vulnerable to eventual rising interest rates. Energy is still very much in the dumps.


Shifting over to fundamental indications, we see (pink shaded area) that the operating earnings growth forecast for 2016 has been reduced significantly since the beginning of the year — 2.7% growth is seen now versus 6.8% as of December 31, 2015. And 2016 revenue growth expectations have declined from 4.3% to 1.6%. Those are big adjustments, with a negative tilt.


As is typical on distant projections, 2017 is forecasted to be much better, with energy profits roaring back, contributing to a small upward earnings growth adjustment from 12.8% to 13.2% from December to now. Likewise, the upward adjustment to revenue expectations is mild going from 5.7% to 6.1%.



Importantly, reported GAAP earnings have been falling for several quarters now (the red line in the chart). You can see from this chart that in the past when reported earnings declined, so did stock prices. Unless reported earnings pick up it is not reasonable to expect must price improvement. With declining earnings forecasts, it is hard to get too excited about stock prices.

For background, the bottom three panels present in order top to bottom: S&P 500 earnings yield (inverse of P/E); S&P 500 earnings yield less 10-year Treasury yield; and S&P 500 dividend yield less 10-year Treasury yield. Those are all competitive levels in this low interest rate environment, which may limit stock market downside potential.



The yield curve is an important economic driver, predictor of recessions and booster or killer of Bull markets. When short-term Treasury yields approximate or exceed long-term rates, the curve is “flat”, and economic activity is suffocated (bad for stocks). When the short-term rates are much lower than long-term rates, the curve is “steep” and economic activity is typically stimulated (good for stocks).

This chart shows the ratio of the 3-month yield to the 10-year yield (green) and the ratio of the 2-year yield to the 10-year yield (orange). While the curves are not as steep as they were a few years ago, they are still stimulative, and good for stocks.

This is one important pillar of support for stock prices, that may limit stock declines.



The yield spread between Moody’s BB rated (higher rated junk bonds) and comparable maturity Treasuries rose a lot over the past year, and was part of the worry contributing to the stock Correction. Very lately, however, the spread has narrowed lot, which is a good sign for stocks.



This chart of the financial system stress levels from the St Louis Fed and the Cleveland Fed (covering lots of debt market, stock market and real estate market dimensions) have shown rising stresses, which is not good for stocks.



The Investors Intelligence Bull/Bear ratio (for professional investors) is very low at about 1 on a scale where less than 1 Bearish; where 1-2 is normal range; and more than 2 is Bullish. It is basically where it was during the last two European debt crises. That is either bad for stocks or good, depending on if you think extreme readings are contra indicators

The American Association of Individual Investors Bull/Bear ratio is about 50/50 Bulls and Bears. No help there either way.


Flow of money into and out of stocks and funds is also an important factor to consider. This chart plots our weekly Demand index for the S&P 1500 stocks (in red) versus the price of the S&P 500 index (in black and orange). This demand index shows net demand (net buying) when the value is greater than 50 (left scale) and net supply (net selling) when the value is less than 50. We calculate this index by considering the weekly price change of each stock in the S&P 1500 and the volume of shares traded in each stock during the week (formula provided below chart).

You can see the index went from Net Demand to Net Supply a few months before the S&P 500 August 2015 Correction, giving some advance warning.

The last 3 weeks have seen very strong Net Demand (upper circled area), but the 13-week and 40-week average demand is still negative for the broad market (lower circled area).

This measure is inconclusive at the moment.



An important analysis of the contribution to demand came from Bloomberg today, in which they pointed out that investment funds have had a net negative flow of money for the past 5 quarters, and only due to corporate stock buybacks did the demand stay positive. Important risk comes from the possibility that corporations may be approaching a full stomach on debt, and that the cost of servicing debt may rise in the near terms, and that corporate earnings decline further. If those factors were to significantly slow corporate stock buybacks, the impact on stock index prices would probably be strongly negative. Buybacks may not decline until the next recession as they did in 2008, but their behavior needs regular observation.


A short-term look at registered investment fund flows looks like this. Over the past 5 weeks, equity funds have had net negative flows, until last week, where it appears investors began chasing the current rally. Given the lag in retail investor decisions, that flow may continue for a few weeks whether or not this rally continues or fades.




This 1-year, weekly chart of world stocks (VT), US stocks (VTI), developed markets stocks (VEA) and emerging market stocks (VWO); as well as aggregate US bonds (BND), shows the rally is global, but so far has not achieved a net positive return over a 12-month period. US stocks are in the best shape. Emerging markets are in the worst shape.


This 1-year chart of US corporate bonds versus aggregate US bonds (which include Treasuries) shows long-term corporate bonds (VCLT) and high yield bonds (HYG) are in net negative return, but have undergone a strong rally in the past few weeks. Intermediate-term corporate bonds (VCIT) just edged out aggregate bonds (BND), and short-term corporate bonds (VCSH) are also positive and not far behind intermediate and aggregate bonds.


In the commodities space, gold has had a solid rally from about negative 8% to about positive 8% during the stock Correction, but has leveled off during the stocks rally. With interest rates low, and if the S&P 500 enters a new Correction or a Bear, gold may well continue its rise. Some key analysts, such as those at Goldman Sachs, still think gold will decline to or somewhat below its 2015 lows.

Corn (a key ingredient in the making of both foods and fuels) is the second best performer at negative 4% over a year.

Natural gas is the worst performer at almost negative 34%. We hear a lot about oil prices, but natural gas is worse over the past years. Oil is down only 14+% over a year, after a big rally (we think a head fake) based on talk between Saudi Arabia and Russia about limiting oil production at current levels IF others will do the same – that appears unlikely, and Iran has said as much for their production.

Copper has rallied too, but is still down over 16% for 12-months.


Abundant natural gas has kept its price low for years, the relatively recent fracking industry achievements have created an abundance of oil that has brought its price down too.


Taken altogether, we are still in the Bearish camp, until breadth improves at a minimum. For our clients with stocks and bond portfolios, we recommend being at the more defensive end of their investment policy range. For clients with stock only portfolios, we recommend being nor more than 50% invested, and then only in solid, high quality core positions. For investors who are young and making regular periodic investments, we recommend equity only and continuation of accumulation in whatever mix of domestic and international stocks is in their plan.

Feel free to call and discuss as this pertains to your specific circumstances and portfolio.