Archive for the ‘market outlook’ Category

Extremes and Divergences for the S&P 500

Monday, April 2nd, 2018
  • Two conditions often precede market trend reversals: extremes and divergences.
  • S&P 500 may have difficulty achieving a 10-year annualized nominal 5% return.
  • Buying Pressure is now less than 1/2 of combined Buying Pressure and Selling Pressure, after many months of decline.
  • Allocate Own and Loan at low end of personal investment policy
  • Hold dry powder

Two conditions that often precede market trend reversals are extremes and divergences.

Extreme conditions tend to revert toward median levels, and divergence between functionally linked dimensions is unnatural, and tends to cause them to adjust until they are generally aligned again.

There are significant current extremes and divergences in US stocks that provide reason for caution and expectation of continuation of the current Correction.

Extremes and divergences are the setups, but they need something to cause investors to change their outlook and trigger the trend reversal — often a surprise or shock from outside of the stock market, but we don’t know what, when, where or how great they will be — otherwise they would not be surprises or shocks.

We can, however, measure how far the rubber band is stretched – how extreme a condition is, or how large a divergence is between related dimensions. The more the rubber band is stretched, the more likely is it to break, or how hard it will snap back to its normal shape when the force stretching it lets go.

The most widely referenced valuation metric is the trailing P/E ratio. It is high now at nearly 25. Here is a chart of the annualized returns for the 10 years following various P/E ratios:

(click images to enlarge)

Based on history of quarterly rolling years from 1881, there is little prospect of a nominal annualized turn as high as 5%, and a reasonable chance of an annualized return less than 0%
The Shiller CAPE Ratio is also popular. It is the price divided by the inflation adjusted 10-year average earnings of the S&P 500 (meant to capture a business cycle, not just a single year somewhere within a cycle).
The picture is worse for price appreciation prospects. A 5% nominal return is not likely and the potential for a negative return is higher than when considering the traditional 12-month trailing P/E.

Looking beyond just P/E multiples, here are some of the stretched and extreme measures for the S&P 500:

If the earnings of the S&P 500 grow over the next 10 years at the long-term historical rate of 6.6% per year, and if the valuation reverts to the median levels (a plausible scenario, not a specific forecast) earnings would increase about 89%, but valuation multiples would decrease, causing the price to rise less than 89%. If one of the average percent change to median measures in the table above prevailed, this would result:

  • 14.79% change to median: net price rise by 61%, 4.90% annualized return
  • 27.73% change to median: net price rise by 37%, 3.19% annualized return
  • 40.67% change to median: net price rise by 12%, 1.18% annualized return.

There are some important breadth divergences now that deserve attention (as of 03/30/2018).

Net Buying Pressure is less than 50% (= Net Selling), as this chart illustrates. This is not a value indicator like those we just discussed. It is trend indicator. The Buying Pressure has been deteriorating for many months, while the price of the index was rising – a key divergence. The index is in Correction which is in alignment with the Pressure. We need to see Buying Pressure turning up before the index can be expected to exit Correction.

S&P 1500 Constituents in Correction, Bear or Severe Bear have been above the 4+ year median but were improving until the current Correction. The percentage of constituents in Correction is in harmony with the index Correction, and the Bear and Severe Bear levels are beginning to harmonize. We will want to see these indicators turn back down for any recovery in the index price to be believable.

Popular Trend Indicators:

The press has made the position of the price versus the 200-day average a popular indicator of Bullish or Bearish conditions; and to a more limited extent popularized the direction of the leading edge of the 200-day average. Here is where they stand as of the end of market today (04-02-2018).

These are not divergences, but confirmation of the underlying deteriorated underlying index conditions:

With 40% to 45% of stocks showing a downward sloping tip to their 200-day trendline, and more than half with prices below the trendline; and 45% to 50% with the price below the 200-day trendline for at least 3 days, the Correction is still firmly entrenched.

Other Oddities:
Typically, in Bull markets, analysts reduce their earnings forecasts as the quarter proceeds. During the last 20 quarters they reduced their estimates on average by 3.9%, and by 5.5% during the last 40 quarters, and by 4.1% over the last 60 quarters. However, in Q1 of this year, they increased their forecasts by 5.4%; the largest increase in any quarter since FactSet began tracking the changes in 2002. The previous largest increase was 4.8% in 2004, an early Bull market recovery period.

At the same time, they raised estimates, the stock market has been in correction – an interesting divergence.

How Are We Positioned?
Our client managed and advised portfolios have widely varying allocations, because they are customized, and the clients have widely varying ages, wealth, withdrawal needs, other income, and other assets; including private funds, venture capital and direct real estate ownership and development.

Of the marketable assets we hold or advise for them, the OWN allocation ranges from 100% to about 50%. LOAN allocations range from 0% to about 35%, with various combination in between.

Current general advice for those who have completed all or most of their accumulations is to have an OWN allocation at or near the bottom of their policy range, to have LOAN allocation at the bottom of their policy range, and to focus on quality credit and variable rates; and to hold the balance in RESERVE until the current Correction shows credible evidence of recovery.

This is a 3-year weekly chart of the price performance of the S&P 500 (blue) and 10-year US Treasury (gold):

1-Yr Daily Volatility of Key Asset Categories Over 10+ Years (Watch Out)

Tuesday, December 12th, 2017

The level of calmness in the markets, as evidenced by daily volatility, is unusual and disconcerting.  Rising interest rates and probably peaked out corporate leverage and profit margins are likely to increase volatility; and unintended consequences of US tax law changes may add surprises on top.

There is not much room for less volatility.  Don’t get too comfortable.  2018 is likely to be a bumpier ride than 2017.

These charts of 1-year daily percentage volatility beginning in 2005  or 2006 show the very low, in some cases 10-year low volatility for key asset categories.  The exception is very short-term Treasuries which are increasing in volatility from a depressed level, as the Fed begins to raise the overnight rate.

(click images to enlarge)

S&P 500 Stocks (SPY)

Non-US Development Markets Stocks (EFA)

Emerging Market Stocks (EEM)

Gold (GLD)

Long-Term Treasuries (TLT)

Short-Term Treasuries (SHV)

Equity Market Conditions Assessment & Portfolio Allocation Intentions 2017-03-17

Monday, March 13th, 2017

This note has three parts:

  1. Short summary of our current market view and portfolio allocation implications
  2. Bullet point outline of details behind our thinking in 5 segments (Trend, Valuation, Sentiment, Breadth, Forecasts)
  3. Supporting graphics for most of the bullet points provided in 24 charts and tables.

The short summary is of our market view and intended allocation actions for discretionary accounts, and recommended actions for coaching or “prior approval” accounts

For those of you who want a feel for why we have our market view and why we believe the allocation changes are appropriate; the bullet points will help.

If you want to see what data is behind most of the bullet points, you will want to look at the 24 supporting graphics.

There is an unfortunate need to use some jargon in the bullet points and graphics which may be unfamiliar to some of you, so please call or write in to have any of them explained; and to discuss their significance to portfolio decisions.


Major world equity markets are in up trends — but there is mounting evidence that the US markets are over-extended and significantly vulnerable to a meaningful downward adjustment based on a combination of valuation, breadth, possible turmoil from key elections in Europe; and as Goldman Sachs puts it “rhetoric meets reality” in Washington.

Downside risk exists, but while the trend remains upward, we are remaining invested.  However, we are not committing additional assets from cash positions to US equity risk positions at this time (except for dollar-cost-averaging programs) due to the elevated vulnerability of the US stocks market.  We will be transferring some of the US equity risk assets in portfolios to some international markets that are in intermediate-term up trends that offer better valuation opportunities.

Portfolio changes or recommendations will be framed within the strategic allocation policy level of each client which varies based on individual needs, goals, stage of financial life, preferences, risk tolerance, and other limits or factors.

Based on valuation and long-term forecasted returns, US stocks exposures will transition from the higher end of individual portfolio policy allocations to the long-term strategic objective levels, or a bit below.  We are currently underweighted non-US developed markets and emerging markets allocations, which we will gradually raise to the long-term strategic allocations levels of each individual portfolio’s allocation policy.

Emerging markets have a more attractive valuation level than other non-US international stock markets (although they pose significantly more volatility), and allocation to them may be raised somewhat above strategic target levels within individual permitted allocation ranges.

For determination of intermediate trend status, we relay on our monthly 4-factor indicator. For more information about our trend following indicator and its performance implications, click here to see our descriptive video.


  • TREND (see Figures 1-6): The intermediate-term stock trends are:
    • United States – UP
    • Non-US Developed Markets – UP
    • Emerging Markets – UP
  • VALUATION (see figures 7-12): Based on history:
    • United States – Expensive on Price-to-Book and Price-to-10yrAvEarnings and not expensive when earnings yield is compared to Treasury yields.  However, when rates rise the comparison will worsen, making stocks more expensive.
    • Non-US Developed Markets – Moderately expensive on Price-to-Book and moderately inexpensive on Price-to-10yrAvEarnings
    • Emerging Markets – Significantly Inexpensive on Price-to-Book and Price-to-10yrAvEarnings
  • SENTIMENT (see Figures 13-17): for US stocks are:
    • Institutional Investors – are reducing equity allocations (a Bearish indication)
    • Investment Newsletter Writers – Bullish at record high levels (a Bearish contra indication)
    • Individual Retail Investors – strongly Bearish this week but neutral last week
    • Options Market – complacent to mixed (jargon terms defined below):
      • Volatility Index – below 200-day and long-term average (complacent, expects smooth ride next 30 days)
      • Skew Index – above 200 day average and long-term trend line (nervous about possible large downside move, next 30 days)
      • Individual Equities PUT/CALL ratio – is 9% above its 200-day and its 10-year average (more cautious that institutional investors)
      • Index PUT/CALL ratio – is 7 % above 200-day average and 4% below its 10-year average (cautious but mixed signal)
  • BREADTH (see Figures 18-21) the trends are:
    • Percent of S&P 1500 stocks in Correction, Bear or Severe Bear have decidedly turned up (Bearish)
    • Percent of S&P 1500 stocks within 2% of their 12-month highs have decidedly turned down (Bearish)
    • The net flow of money is into S&P 1500 stocks over 3 month, 6 months and 1 years, but the leading edge of those flow has turned down
    • The net flow is explained by the net Buying Pressure declining substantially more than the Selling Pressure; and both measures are at levels below the 12-month average indicating reduced overall force driving the market
  • FORECASTS (see Figures 22-24):
    • “Street” consensus 2017 S&P 500 earnings growth 8.9% on revenue growth of 7.2%
    • “Street” consensus 2018 S&P 500 earnings growth of 12.0& on revenue growth of 5.1%
    • Consensus 3-5 year earnings growth for S&P 500 is 8.89%
    • Consensus 3-5 year earnings growth for MSCI non-US developed markets stocks index is 8.76%
    • Consensus 3-5 year earnings growth for MSCI emerging markets stocks index is 10.37%
    • Consensus 3-5 year earnings growth for MSCI core Europe stocks is 8.11%
    • Consensus 3-5 year earnings growth for MSCI Japan stocks is 9.43%
    • Consensus 3-5 year earnings growth for MSCI China stocks is 7.13%
    • Bank of America/Merrill Lynch just raised its 2017 S&P 500 price target from 2300 to 2450
    • Research Affiliates (leading factor based investor) forecasts 10-year real (after inflation) returns:
      • US large-cap stocks 0.7% (with 14.4% volatility)
      • US small-cap stocks 0.5% (with 19.6% volatility)
      • Non-US Developed Markets stocks 5.4% (with 17.0% volatility)
      • Emerging Markets stocks 7.0% (with 23.3% volatility)
    • GMO Bearish Mgr (lowest min fund investment $10 million available) forecasts 7-year real returns
      • US large-cap stocks – negative 3.4%
      • US small-cap stocks – negative 2.7%
      • Large International stocks – positive 0.2%
      • Emerging Market stocks – positive 4.1%
    • BlackRock (fund manager in the world) forecasts 5-year nominal returns
      • Large US stocks 4.1% (with 15.5% volatility)
      • Small US stocks 4.1% (with 18.7% volatility)
      • Large International stocks 5.5% (with 18.5% volatility)
      • Emerging Markets stocks 5.5% (with 23.3% volatility)

Options Jargon Description:

VIX: VIX is the options pricing implied volatility of the S&P 500 index over the next 30 days, based on at-the-money options

SKEW: SKEW measures the relative options “implied volatility” (essentially price) of S&P 500 out-of-the-money PUTs versus out-of-the-money CALLs with strike prices the same distance from the market price – essentially measuring the perceived “left tail risk” (tail risk is the probability of prices going below the level that is predicted by a normal probability Bell curve).

Portfolio managers are predisposed to buy PUTs for protection and sell CALLs for yield, which tends to increase out-of-the-money PUT premiums and depress out-of-the-money CALL premiums.

SKEW of 100 means the market expects equal implied volatility (essentially prices) for out-of-the money PUTs and CALLS.  SKEW greater than 100 means the market expects higher implied volatility (prices) for PUTs relative to CALLS – more perceived large downside risk.

The record low SKEW was 101.9 on March 21, 1991. The long-term average SKEW is around 115, and the high is around 150. The current 200-day average SKEW is about 130, and the current level is about 140. That means there is a heightened concern about a greater than typical risk of a large downside move in US stocks.

INDIVIDUAL EQUITIES PUT/CALL RATIO: The Equities PUT/CALL ratio is the PUTs volume divided by the CALLs volume on individual stocks. This tends to be reflection of actions by retail investors; and is often a contrary indicator.

INDEX PUT/CALL RATIO: The Index PUT/CALL ratio is also the ratio of the volume of PUTS and CALLS, but tends to be a reflection of the actions of institutional investors; and is not considered a contrary indicator.


(click images to enlarge)


Over the past year, US stocks (VOO), non-US Developed Markets (VEA) and Emerging Markets (VWO) are generally in an up trend, although the US is way out front.

Over 3 years, the three regions are up, but the US is way ahead, and did not have as severe down moves as the other two regions.

As you will see the outperformance by the US is related to its current overvaluation, and the weaker performance of the other markets, is related to their more attractive valuation.
Our 4 factor monthly trend indicators ranks each of the three regions as in an up trend.
This time series of our trend indicator for the US shows the up trend established since March 2016.
The up trend in non-US Developed Markets was established in November 2016.
The up trend in Emerging Markets was established at the end of December 2016.


On price-to-book basis the US is very expensive (at the top of its 10-year range). Non-US Developed Markets are “normally” valued (at just above their median level). Emerging markets are inexpensive (price significantly below their median level).
In terms of the Shiller CAPE Ratio (price vs 10-year inflation adjusted average earnings), the US is very expensive relative to is long-term history. Developed Markets are inexpensive, and Emerging Markets are significantly inexpensive.
Based on a variety of valuation metrics the US is expensive. The Developed and Emerging Markets inexpensive by comparison.  Emerging Market have more attractive valuations than the Developed Markets.

In terms of profitability, the US is tops, which partly explains the higher valuation. Developed Markets are less profitable than Emerging Markets.

Emerging markets have competitive dividend yields and the lowest payout ratios.

Emerging markets seem to be a bit less leveraged than US stocks, and the Developed Markets are the most levered.

In addition to the price-to-book and Shiller P/E to their respective histories, several other valuation metrics for the US should be considered; almost all of which suggest the market is very expensive

The “equity risk premium” [(stock earnings / price) – (10-yr Treasury yield)] is the only key valuation metric that suggest that stocks may not be overvalued; and that argument depends of the current historically low Treasury yields.


Current equity risk premium for the 10-year inflation adjusted earnings-to-S&P 500 price is 0.90%. Since 1881, the equity risk premium for the S&P 500 and its large-cap precursors was higher 68% of the time.  That suggest modest overvaluation.

However, since the risk premium first went negative in 1964 (except for 4 months in 1929), the equity risk premium was only higher than now 30% of the time — a Bullish suggestion.

The question is whether the 135 history, or the 52 year history is the more important to consider. If the long history is more important, then the S&P 500 is somewhat expensive relative to the yield on 10-year Treasuries; but if the shorter history is more important, then the S&P 500 is inexpensive relative to Treasury yields.  However, Treasury yields are suppressed, and if they normalize to something in the 3% to 4% range before profits increase a lot, then stocks are expensive.
Current equity risk premium for the 12-month trailing earnings-to-S&P 500 price is 1.17%. Since 1881, the equity risk premium for the S&P 500 and its large-cap precursors was higher 68% of the time.  This also suggests moderate overvaluation.

However, since that risk premium first went negative in 1967 (except for 1 month in 1921), the equity risk premium was only higher than now 29% of the time — a Bullish indication.

The question is whether the 135 history, or the 49 year history is the more important to consider. The same logic applies as it does for the equity risk premium based on the 10-year inflation adjusted earnings yield.

S&P 500 GAAP earnings are not much higher than they were 4 years ago, yet the price of the index is a lot higher. That means much of the rise in the price of the index is merely paying more the what you get, not getting proportionately more for paying more.

10-year Treasury rates in 2013 more than doubled from less than 1.5% to more than 3%, yet the S&P 500 continued to rise in price faster than earnings.

Once again 10-year Treasuries have risen in 2016 from less than 1.5% to more than 2.5% and the price of the S&P 500 has continued to rise, even in the face of flat earnings, with falling earnings close behind in the rear view mirror.

If interest rates should make it to 3% in the near-term (not an unthinkable event), the equity risk premium on trailing 12-month earnings would drop from 1.17% to about 0.75%. Since 1881, the risk premium has been higher than 0.75% more than 70% of the time; and since 1967 it has been higher 64% of the time.  That would be Bearish.

This suggests valuation vulnerability in the face of probable moderate interest rate increases.


The State Street Investors Confidence index is a behaviorally measured sentiment index — a measure of increases or decreases in public equity allocation in actual institutionally managed portfolios, a real measure of market sentiment by large institutions.

The rate of increase in their public equity risk allocations began a decline in around 2 years ago.  They began actually decreasing their public equity allocations in 2016 and continue to do so.

This is not an endorsement of current stocks markets.
Investors Intelligence monitors 100 leading investment newsletters to gauge the Bullish or Bearish sentiment of those writers. Extreme peaks in sentiment tend to be contrary indicators (not perfectly, of course), but when “everybody” is Bullish or Bearish, a trend is often about to be exhausted; because there are few additional people to join the point of view and bring move more money in the direction of the trend.

The current Bull-Bear spread is among the most extreme Bullishness of the last 10 years.  This suggests that a corrective action is likely nearby.

The American Association of Individual Investors conducts a continuous online survey of it members — essentially the retail investor.  Last week when this chart was created, the Bull-Bear spread was 2.29%, barely on the Bullish side of neutral.  In the subsequent week it turned on a dime dropping to negative 16.5%; strongly Bearish.

The chart suggests that this data is more a coincident indicators than a forward indicator, so the drop in sentiment parallels the recent weakness in the up trend.
TD Ameritrade publishes the Investor Movement Index.  It is Bullish at this time.  Here is what they do to make their index.

Each month Ameritrade calculates a short-term Beta (volatility relative to a benchmark such as the S&P 500) for each security.
Then it takes a sample of hundreds of thousands of customer accounts with at least $2,000 in their account and in which at least 1 trade was done the month, from its approximate 6 million customers.
It measures the total equity allocation and the aggregate short-term Beta (volatility relative to volatility of the S&P 500) of the equities in each portfolio (and other undisclosed factors) to develop the risk level of each portfolio.
Then equal weighting each account without regard to size or number of trades, it finds the median equity risk exposure, and puts that on its index scale (scale parameters not disclosed), and plots that versus the S&P 500.
The level and direction of the index is an indication of actual retail investor behavior instead of what they might say about their sentiment.

The options market reveals the actual risk taking behavior of investors in terms of the pursuit of gain (buying CALLs) or seeking protections (buying PUTs).  Here are 4 measures of options market behavior.

VIX measures the expected volatility of the S&P 500 over the next 30 days.  At under 12, the VIX is well below the 10 year average of about 20, and among the lowest levels of the past 10 years.  This is complacency.  Complacency is probably like everybody being on the same side of a boat, which makes the boat prone to tip over.  Volatility is a mean reverting measure, which suggest more volatility in the relatively near future than in the relatively near past.

The SKEW Index (defined above in the jargon section) is a measure of the concern over the size and probability of an unusually large downside move.  That measure is elevated, which gives reason for caution.

The Equity PUT/CALL index (defined above in the jargon section) is a measure of the relative “protection seeking/opportunity seeking” behavior of mostly retail investors.  That ratio is slightly elevated versus average levels, indicating a mildly increased relative pursuit of protection.

The Index PUT/CALL index (defined above in the jargon section) is a measure of the of the relative “protection seeking/opportunity seeking” behavior of mostly institutional investors.  That ratio is slightly lower than average, indicating a mildly lower than average relative pursuit of protection.
This is one of our favorite measures, and one that we directly measure weekly since the beginning of 2014.  Breadth measures the condition or behavior of the overall membership of the broad S&P 1500 index and compares it to the price level of the market-cap weighted S&P 500 index — in other words, it checks to see if the rank and file members of the market are going in the same direction as the mega-cap leaders of the market.

For example, the price movement of Apple and Exxon have a lot more impact of the price of the S&P 500 or the S&P 1500 than 100’s of smaller members of the S&P 500 and S&P 1500.  If the rank and file are going in the same direction as the leadership, that is Bullish breadth.  If they are going in the opposite direction, that is Bearish breadth.  The leaders can only go so far for so long without the rank and file coming along.

The percentage of S&P 1500 index constituents in a Correction or worse (grey line — down 10% or more from their 12-month high) rose dramatically before the November presidential election, then dropped off just as steeply to among the lowest levels in the past 3 years.  Just recently, however, the percentage in Correction or worse sharply turned up — still in “normal” range, but the direction change is a negative for the current stocks rally.

The same is true, but to a lesser extent for the percentage of S&P 1500 stocks in a Bear or worse (blue line — down 20% or more), or in a severe Bear or worse (red line — down 30% or more).
The percentage of S&P 1500 stocks within 2% of their 12-month high was declining prior to the election, turned up sharply to reach the highest level in the past 3 years immediately after the election, but has since declined to the “normal” range with a current downward direction.  The provides a note of caution about the current rally.
The Net Buying Pressure (Buying Pressure / Sum (Buying Pressure + Selling Pressure), which has been net positive since the bottom of the early 2016 Correction, began to decline before the election; resumed growing strength after the election; but has recently been losing steam.  This is not supportive of the current rally.


The separate Buying Pressure and Selling Pressure components of the S&P 1500 stocks Net Buying Pressure in the figure above are shown here.

The rising S&P 500 price in 2016 was not matched by rising Buying or Selling Pressure, showing waning enthusiasm for equities.  After the election both Buying and Selling Pressure rose, but Buying Pressure rose more than Selling Pressure.  Recently however, the decline in Net Buying Pressure noted above, is the result of Buying Pressure declining substantially, while Selling Pressure has declined far less.

These data also suggest the fuel of the rally may be running low.

Looking way down the road with 5-10 year forecasts, and supporting our view that a shift in allocation more toward international equities, and less in US equities is appropriate, are forecasts by Research Affiliates (a noted factor-based asset manager), by GMO ( a Bearish asset manager for the very wealthy — $10 million and up to invest in their funds); and by BlackRock (the largest fund manager in the world).
Research affiliates studies factors with focus on the current Shiller CAPE Ratio (Price divided by the inflation adjusted 10-year average Earnings) relative to its historical median, and historical highs and lows.  They find that to be a good long-term indicator of opportunity.  They view the CAPE Ratio as mean reverting over the long-term.

Based on CAPE and other factors, this chart shows how they see the real (nominal less inflation) return and the volatility of US, non-US Developed Markets (“EAFE”) and Emerging Markets (“EM”) working out over the next 10 years on an annualized basis.  They definitely see international equities as the place to be — but with more volatility.

GMO does not disclose their forecasting methodology, but they are among the most Bearish institutional manager, so worth noting for that.  Over the next 7 years, they see the real return on US large-cap stocks as negative 3+%; the real return on large international stocks as barely positive; and the real return on Emerging Market as positive 4+%.  They also see negative real returns on US and Dollar hedged international bonds, but positive 1+% real returns on Emerging Markets debt.

Over the next 5 years, BlackRock sees nominal return on US stocks as very low, and much lower than international stocks.  They see non-US Developed Markets stocks as generating nominal return  at about the same level as Emerging Markets, but with volatility similar to that of US small-cap stocks; whereas they see much higher volatility for Emerging Market stocks.



Lowered Long-Term Portfolio Return Expectations: Mean Reversion Impact

Tuesday, August 9th, 2016

QVM Clients:

  • Current stock and bond trends are mostly up and S&P 1500 breadth indicators have normalized
  • S&P 500 is approximately at consensus 2016 price level
  • Mean reversion risk is substantial but timing of realization is unknown
  • Institutional long-term asset return assumptions are lower and portfolio return expectations should be tempered
  • Specific mean reversion risks presented in charts

The current trend is generally up, with non-US developed markets struggling, and emerging markets transitioning to clear up trend. Here are the trend ratings for ETFs representing key asset categories commonly found in portfolios. The ratings are based on the monthly four factor indicator used by QVM:

  • Direction of tip of 10-month moving average
  • Position of price above or below the 10-month moving average
  • Net buying or net selling pressure
  • Price position versus a progressive threshold changing at a geometric pace

As additional information, the table provides the price percent below the 12-month high price; the price position within the 12-month high-low range, the overbought or oversold condition based on the money flow indicators, the positive or negative signal from the MACD signal line, and whether the MACD is above or below the center line.

Even though current trends are up, the Bull is aged and probably in late stages, with significant long-term risk associated with eventual withdrawal of central bank market distortions. Cautiousness and conservatism is warranted.

(click on images to enlarge)


Fear of loss and risk avoidance are important emotional and behavioral factors that are about twice as strong as satisfaction with gains and opportunity seeking emotions and behavior. That gives us some pause talking about long-term risks. We do not want to frighten anybody or cause them to, as Jeff Gundlach said, “Sell Everything”. Market performance problems that are certain to be upon us someday are not upon us now, and within reason, we must take advantage of current positive trends. But we want you to be aware of the nature of the problems that will most certainly be realized some uncertain time in the future. There are important setups of valuations that are too far from long-term mean levels to be permanently sustained, and that are the basis of multiple institutions cautioning investors of subdued returns over the next decade.


In June a survey of institutional investment strategist saw the S&P 500 ending 2016 at around 2100 to 2200. We are pretty much there now, suggesting not a lot of upside over the remainder of the year, which also dovetails with the likely reluctance of investors to be fully exposed to market risk during this unusual presidential election.



We have been in the Great Distortion for years now, and “mean reversion” can gettcha if ya don’t look out. Unfortunately, while mean reversion is a near certainty, when reversion takes place is not. Wide deviations from “normal” levels can go on for long periods (but can also revert quickly). Our central bank and those of Europe, Japan and China have been doing things to prevent mean reversion for years now. Someday the forces of mean reversion will defeat the central banks if the banks don’t toss in the towel on their distorting efforts first.

Before a general look at overvaluation and mean reversion in the S&P 500, here from 720 Global is one of the worst cases today of yield chasing that has put utilities into rarefied territory with very strong mean reversion risk.

The image below shows the S&P 500 sector ETF (XLU) Price-to-Sales ratio is more than 3 standard deviations above its average since 1990; and the Price-to-EBITDA ratio is nearly 3 standard deviations above. Valuations 3 standard deviations from the mean have odds stacked well against them being sustainable.

The price would be cut in half to get back to average Price-to-Sales ratio, or cut by about one-third to get back to average Price-to-EBITDA. That is not an attractive risk for a slow-growing industry. This problem caused by the frantic search for yield that has raised the price of typically high yield or strong dividend growth companies to unattractive valuation levels.

The need eventually to move valuations back toward the mean levels in key asset categories is the reason so many forecasters see muted portfolio returns in coming years.

2016-08-08_02The current trends in US stocks, and bonds are up right now, which is itself unusual as a pair. They are all marching to the tune of ZIRP and NIRP (zero interest rate policy and negative interest rate policy), which cannot go on forever – a long-time yes, but not forever. When rates normalize (revert to mean), so too will stocks and bonds. Interest rates are at the base of most aspects of investing, and tend to drive valuation of other assets. Having some idea what normalization would be is important to setting expectations.

A wide variety of institutional voices have concluded and published their expectation of lower portfolio returns over the next several years, as a result of the significantly above normal returns of the past several years. They talk of interest rates rising, profit margins declining, revenue growth slowing or not accelerating, valuation multiples compressing, debt servicing costs rising, reduced stock buybacks resulting in less boost to earnings per share, and just general world GDP slowing or moderation.

Looking across their prognostications and generalizing, it seems they expect a 4% to 5% total return over the next 5 to 10 year for a 50/50 stock/bond balance portfolio.


McKINSEY & COMPANY (largest independent management consulting company)
In May of this year McKinsey & Company published a report titled “Diminishing Returns: Why Investors Need to Lower Expectations”. They see much lower asset returns, and therefore lower portfolio returns, in effect due to mean reversion.



Based on the mid-point of McKinsey’s view a 50/50 US stock/US bond portfolio would tend to return an approximate 5.25% nominal annual return over the next 20 years.

BLACKROCK (largest asset manager in the world – $4.5 trillion AUM)
BlackRock sees similar lower asset returns.


Based on BlackRock a 50/50 US stock/US bond portfolio should expect a long-term nominal annual return of about 2.55% over the next 5 years and about 3.5% over the “long-term” (undefined length of time).

VANGUARD (second largest money manager – $3.3 trillion AUM)
Vanguard had this to say last December with a less pessimism:

“Vanguard’s outlook for global stocks and bonds remains the most guarded since 2006, given fairly high equity valuations and the low-interest-rate environment …The growth outlook for developed markets, on the other hand, remains modest, but steady … our medium-run outlook for global equities remains guarded in the 6%–8% range. That said, our long-term outlook is not bearish …the high-growth “goldilocks” era enjoyed by many emerging markets over the past 15 years is over. Indeed, we anticipate “sustained fragility” … China’s investment slowdown represents the greatest downside risk.”

JOHN BOGLE (Founder of Vanguard Group)
6% nominal (non-inflation-adjusted) equity returns during the next decade; 3% bond return

Based on Vanguard’s view a 50/50 US stock/US bond portfolio would tend to generate a 4.5% annual nominal over the next 10 years.

STATE STREET GLOBAL ADVISORS (third largest money manager – $2.3 trillion AUM – sponsors of SPDRs including SPY)


Based on the State Street forecast a 50/50 US stock/US bond portfolio should expect an approximate annual nominal returns as follows over various time frames:

  • 1-year: 1.85%
  • 3-years: 3.60%
  • 5-years: 3.95%
  • 10-years: 4.4%
  • 30-years: 4.85%.

JP MORGAN ASSET MANAGEMENT (prominent high net worth, private wealth manager)

This is the long-term view from JP Morgan Asset Management as of their annual outlook for nominal returns over the a 10-15 year time frame:


Based on JP Morgan forecasts a 50/50 US stock/US bonds portfolio might expect an annual nominal return of 5.63% over the next 10-15 years.

NORTHERN TRUST (prominent high net worth private wealth manager)

“We expect developed market equity returns of 5.4% annually, bookended by emerging market returns of 7.3% at the top end, and US returns of just under 5% at the low end. … We expect real assets to perform relatively well, led by a forecasted return of nearly 7% for natural resources. .. We expect the US 10-year Treasury to support a yield of just 1.5% [over five years], capped by the German 10-year yield of just 0.5% and the Japanese 10-year at 0%. … We do expect an uptick in high-yield bond defaults, but project a 5% total return, which is attractive compared to the outlook for the equity markets. … While we expect to see some modest deterioration in corporate credit quality, continued low rates and strong investor demand should lead to further spread tightening for investment-grade bonds [that suggests continued gains as spreads to Treasuries compress]”

By interpolating/hypothesizing perhaps a 3% aggregate bond yield from Northern Trust comments, a 50/50 US stock/US bond portfolio may generate an annual return of about 4% over the next five years.

GOLDMAN SACKS (prominent high net worth private wealth manager)
Goldman Sachs “Last Innings” 5-year nominal return assumptions.


Based on Goldman Sachs forecasts, a 50/50 US stock/US bond portfolio (it’s a little hard to say because they do not specify US aggregate bonds or investment grade bonds), but let’s take the mid-point between their cash return and high yield return (2.5%) and tweak it up to 3%. That would give a possible 5-year expectation of about a 3% nominal portfolio return.

RESEARCH AFFILIATES (pioneer in “factor-based” investing)
1.1% real returns for U.S. large caps (the S&P 500) during the next 10 years; 1.1% real returns for the Barclays U.S. Aggregate Bond Index

Based on Research Affiliates forecasts a 50/50 US stock/ US bonds portfolio would generate about a 1.1% real return (perhaps 3% to 3.5% if inflation were to be in the range of 2% to 2.5%) over the next 10 years.


The 50/50 forecasts we estimate from the selection of institutions above are:

  • McKinsey 5.25% over 20 years
  • BlackRock 3.5% over the “long-term”
  • Vanguard 4.5% over 10 years
  • State Street 3.95% over 5 years
  • State Street 4.4% over 10 years
  • JP Morgan 5.6% over 10-15 years
  • Northern Trust 4% over 5 years
  • Goldman Sachs 3% over 5 years
  • Research Affiliates 3% to 3.5% over 10 years

Based on their range of thoughts, let’s go with 4% over 5 to 10 years and see how one might get there logically:

  • Stocks return 5% consisting of 2% dividend yield and 3% growth in earnings due to global GDP growth
  • Corporate bonds return 3% average interest, and no capital gains due to rising interest rates
  • 50% x 5% + 50% x 3% = 4% portfolio return.

A 70/30 stock/bond portfolio with the same underlying asset returns would return 4.4% (70% x 5% + 30% x 3%).
A 30/70 stock/bond portfolio would generate a 3.6% return (30% x 5% + 70% x 3%).

One way to potentially do better is to own stocks that pay more than 2% (index level) yield and that are not terribly interest rate sensitive, and that can grow earnings (and revenue) at least at 3% over the next 5-10 years – to get more of the return in regular cash with less reliance on price change.

Another way might be to overweight less popular stock categories, with more favorable valuation, with at least the potential to growth faster than US stocks, perhaps such as emerging markets

A third way could be to have a non-core tactical component of the portfolio that, if successful, could outperform the core.


In great part, long-term assumptions come down to reversion to the mean whether analyzing core portfolios, or tactical opportunities — so let’s look at some prime examples of assets far enough from their mean that significant value changes are in store, when the forces of Great Central Banks Distortion are withdrawn.

Before the mean reversion sets in, there needs to be some sort of catalyst. Central banks are expected to provide that catalyst in one way or the other, either by raising rates, or cutting rates with minimal intended effects. Another catalyst could be investor recognition of obvious problematic divergences.

Figure 1 shows an important problematic divergence.

The S&P 500 price is in black and its reported GAAP earnings are in red. Trailing earnings are falling and the price of the index is rising. That is a divergence setting up for a reversion to the mean (unless of course earnings catch up with the strong price rise). Note that the last two time earnings declined for several quarters, the stock index declined significantly as well. This is a cautionary signal.



Figure 2 shows a problematic divergence based on forward operating earnings similar to the one in Figure 1 which is based on trailing GAAP earnings.
S&P 500 forward operating earnings expectations are relatively flat, but the price of the index rising significantly, This divergence is not normal and sets up for a reversion to the mean (a return to a normal relationship). This is a cautionary signal.



Figure 3 shows that not just earnings, but also profit margins are in decline, and are also above their long-term average. This is a set up for return to the mean, which would be a negative for the S&P 500. If all other valuation factor remained constant, profits (and presumably prices) would come down 8.3% for profit margins to reach their 10-year average.



Here are some important comments about profits and mean reversion:

Warren Buffet (1999) CEO Berkshire Hathaway
“In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.”

Jeremy Grantham (2006) CIO GMO (Grantham, Mayo, & van Otterloo)
“Profit margins are probably the most mean-reverting series in finance…”

John Hussman (2013) President Hussman Investment Trust
“In general, elevated profit margins are associated with weak profit growth over the following 4-year period. The historical norm for corporate profits is about 6% of GDP. The present level is … above that, and can be expected to be followed by a contraction in corporate profits over the coming 4-year period …”

Jason Zweig (2013) writes Wall Street Journal, Intelligent Investor column
“… regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.”

Figure 4 shows aggregate public and private corporate profits as a percentage of GDP. There are way out of line with the norm. This is a setup for return to the mean, in a way that would reduce stock returns going forward. If all other valuation metrics remained constant, the value of American corporations would decline by 27% to reach the mean profits to GDP ratio.

Note the use of the 85th and 15th percentiles as indicator lines. When at the 85th percentile, there is 6 times more room below than above that level (5 times to the 15th percentile level); and at the 15th percentile, there is 6 times more space above than below (5 times to the 85th).



Price-to-earnings ratios are the most popular metric. Figure 5 shows the Shiller CAPE ratio (an inflation adjusted 10-year average reported GAAP P/E ratio). If all other valuation metrics remained constant, the price of the S&P 500 would have to decline by 33.6% for the CAPE to reach the mean.



Figure 6 shows the P/E ratio based on the 12-month trailing reported GAAP earnings. It too is way above normal and set for mean reversion. Such elevated P/E ratios may be justified in the short-term due to exceptionally low interest rates, but when rates eventually rise, as they must, the math used to set reasonable P/E ratios adjusts, and lower P/E multiples will be in order. Note that much of the increase in price in the past few years has been due to multiple expansion and not to underlying organic growth of the companies. When interest rates rise, some of those stock multiples must be given back.

To revert to the 25-year median, the S&P 500 would have to decline by 20% at the current earnings level. To revert to the 135-year median, the S&P 500 would have to decline by 40%.



Figure 7 shows the P/E based on forward operating earnings. Like the 10-year inflation adjusted GAAP P/E, and the 12-month trailing GAAP P/E, the forward operating earnings P/E is also well above its average. To revert to the 10-year average, the S&P 500 would have to decline by 16%.



Figure 8 provides a much longer view of the forward P/E ratio (courtesy of Dr. Ed Yardeni, Yardeni Research inc., Here he has plotted P/E isobars, representing what the index price would be at different P/E levels for the forward earnings view at the time. We added the color shading to make it a tad easier to see stages of valuation at different levels. This chart plots from 1979. You can see that the current forward P/E is in the elevated range (light orange) between P/E 15 and 20. That suggests mean reversion vulnerability.



Really it is easier to think of stock valuation relative to interest rates by expressing stock valuation as an earnings yield versus a Treasury bond yield (yield-to-yield, instead of P/E-to-yield). Earnings yield is simply the inverse of P/E. Instead of P/E it is E/P. Figure 9 shows the earnings yield (“EY”) of the S&P 500 for the past 135 years versus the US 10-year Treasury yield (precursors of S&P 500 before 1957 and precursors of 10-year Treasury in early years, based on data assemble by Dr. Robert Shiller of Yale).

As it turns out the earnings yield is just about right at the median level, meaning the index is properly priced for the current interest rate situation. But the current interest rate situation isn’t priced right and has to change eventually, possibly sooner than later. At that time, the S&PP 500 would be overpriced and prone to price reduction.



Figure 10 shows the US Treasury 10-year rate and precursors back to 1881 (135 years). The recent rate is 1.59% and the median is 3.76%. It has been all over the yield range for the past 60 years, showing its can go much higher under some circumstances. But it is currently at the lowest rate in 135 years, which suggests the only logical probability is up (even if down more for a while). When rates rise, all other investments will make adjustments for the relativities to this theoretically zero credit risk vehicle. As it approaches mean level (or shoots past the mean). Mean reversion will be the name of the game for other assets too.




Back to the present, the breadth damage done in the second half of 2015 and the first quarter of 2016 is healed, and breadth indicators support the current rally.

3-month (gray), 6-month (blue) and 1-year pressure within the S&P 1500 is net to the Buying side and rising after a long period of decline and into net Selling territory in 2014 and 2015.


The percentage of S& 1500 stocks in Correction, Bear or Severe Bear condition has returned to pre-Correction levels and is improving.


The percentage of S&P 1500 stocks within 2% of their 12-month high is in good shape.



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.


S&P 500: Where From Here? (2016-01-22)

Monday, January 25th, 2016

We have been getting calls, asking where the market is going. To be clear, nobody really knows. Markets can do anything – an they usually do. That said there are some technical tools to take reasonably educated guesses about what might happen in the short-term (excluding exogenous changes, such as central bank policy changes, or shocking macroeconomic statistic releases, or some terrible world event).

Fundamental projections are not any more useful in the short-term than technical indications. Fundamentals do determine where markets end up in the long-term, in the short-term emotions, funds flows and world events (and media hype) have a lot more to do with market behavior than fundamental valuation.

Adam Parker, founder of FundStrat, and former Chief Equity Strategist at Morgan Stanley recently had this to say about market price forecasting based on valuation.

“Trying to figure out where the market is going is like taking something we don’t know how to forecast (the price-to-earnings ratio for the market) and multiplying it by something we aren’t very good at forecasting (the earnings for the market). We have always written that we don’t think anyone can forecast the market level P/E ratio in time frames less than a few years.”


  • The primary trend for US stocks and the S&P 500 in particular is down
  • The rally last week was contra trend, but was likely not a reversal of the downward primary trend
  • The current S&P 500 price is far enough below its trend that there is a statistical probability of a contra trend rally to perhaps 1935
  • There are numerous fundamental and macro issues that are applying negative force to continue the downward primary trend
  • Internal breadth of the S&P 500 (as well as other major indexes around the world) is decidedly negative
  • Historical volatility over 1 year, 6 months and 3 months suggest a reasonably likely index price range over the next 3 months between 2250 and 1775
  • The downward path of the primary trend suggest the lower half of the 2250-1775 range is more likely to be realized
  • Fibonacci, Price Channel and Pivot Point indicators suggest the index price may experience resistance in 1935 to 1950 range, 1970 to 1975 and the 2015-to 2025 range


Investors in Accumulation Stage (averaging in): This short-term view of the primary trend is not relevant to most investors with a long time-horizon before retirement, who have chosen their appropriate risk profile, and who are continuing to add capital to their investment portfolio.  Those investors are probably best served by simply maintaining the allocation risk profile they have selected, and going about the business of earning money and saving as much as they can.

Since downturns don’t last forever, and periodic investments buy more shares during downtrend than in uptrends,  short-term trend information may be useful to those periodic investors who can squeeze their household budgets to increase periodic investments during downtrends.

Investors in Withdrawal Stage (averaging out): This short-term view of the primary trend is relevant for those who are in or near retirement who want to reduce the “risk of ruin” (outliving assets) due to  having to sell assets during a decline to fund withdrawals.  Note that retirement portfolios are depleted at an accelerated rate when selling assets during declines, increasing the risk of outliving assets.

For those investors in the withdrawal stage of their financial lives, a recent statement by Bill Gross (formerly CEO of PIMCO and noted bond manager) is relevant.  He said the current market is one for return OF capital more than one of return ON capital.

The risk of ruin is minimized for those investors in retirement who can live out of investment income without selling assets.  Dividend investors may have a lower risk of ruin if their dividend stocks have above inflation dividend growth rates, and thus they may have less interest in short-term trend changes.

Investors With a Desire or Need for a Tactical Overlay: Several sorts of investors occur to us to may find short-term trend information relevant:  (1) those withdrawal stage investors  relying on capital appreciation for a significant portion of their retirement income, (2) those accumulation stage investors who wish to increase periodic investments during downturns, (3) margin investors, (4) options investors, and (5) and other investors in any stage of their financial stage of life who prefer to engage in some form of tactical investing:

  1. Withdrawal stage investors who cannot live out of investment income alone (who must periodically sell assets to fund withdrawals) may wish to use trend information to modulate their debt / equity allocation between minimum and maximum investment policy levels to reduce risk of ruin
  2. Accumulation stage investors may wish to commit more money to regular periodic asset purchases when prices are declining than when rising to improve the average cost of their holdings.
  3. Long or short investors on margin, want to be in line with the short-term trend to avoid leveraged losses and margin calls
  4. Option investing/speculation is short-term in nature due to option expiration dates — they definitely need short-term trend information
  5. Some investors just have a desire to be tactical with a portion of their assets for one reason or the other; ranging from a gaming spirit to the need to sleep well at night.
If for any of these reasons, or mere curiosity, short-term stock market condition and direction is of interest to you, please read on.


The most important fundamental factor for most companies most of the time is the level and direction of profits. That picture for the S&P 500 is not good in the short-term past, and analysts have negative short-term expectations (although they expect 2016 overall to be a positive profits growth year).

These four charts illustrate the negative S&P 500 profits growth picture and the index price together. Each chart shows the price in vertical black bars; the moving average primary trend in gold; the quarterly GAAP reported profits in red; the earnings yield (inverse of the P/E) in the lower panel in black; and the dividend yield in the lower panel in green.

The upper left chart is for year-to-date. The upper right chart is for 3 months daily. The lower left chart is for 1 year weekly. The lower right chart is for 3 years monthly.

The charts show the gold primary trend line in decline and the price below the primary trend line. The 3-year chart, in particular, shows the downward turn in profits in 2015, and the corresponding flattening then decline in the stock index price.

(click images to enlarge)

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Operating earnings (equal to or less than GAAP earnings depending on various charges in GAAP reporting) is expected to be down in 2016 Q1, but then rise during the balance of the year as this FACTSET chart of quarterly operating profits shows:

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Revenue declined in 2015, but analysts expect it to revive in 2016 and 2017 – presumably in great part due to revival of oil and gas company profits (a major wild card).

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Profit margins have been squeezed, but are projected by analysts to revive after 2016 Q1, as this FACTSET chart shows:

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If you believe the analysts (take note of Adam Parker’s quote in the intro to the letter – then not much to worry about. If you focus on what is known and factual at the moment – then the picture is not very good.

Let’s keep these additional facts in the background too:

  • Global growth forecasts being lowered (still positive but lowered)
  • Fear of something nasty happening in Chinese markets
  • Europe struggling socially and financially with the flood of refugees from ISIS
  • Highly deteriorated internal breadth within the US stock indexes (narrow leadership with bulk of stocks in tough shape)


Technical analysis is viewed by many as hocus-pocus nonsense, and that may be true in theory, but the fact is that many people use and rely on technical indicators to make decisions.

The use of technical indicators by a significant group of investors makes them a force in the market, and therefore somewhat meaningful and relevant for short-term price behavior.

Certainly, technical indicators are not perfect or even close, but they do cause a significant amount of money to move in the market in response to them. Even if technical indicators have no theoretical basis, they can become self-fulfilling prophecies if enough investment money is moved on the basis of them.

Technical indicators should probably be looked at in combination and with the assumption that they will often be wrong, but if well used may be right more often than they are wrong – or may be wrong as often as right, but able to stem losses and let profits run.

A significant portion of professional money managers use a combination of fundamental and technical (as well as thematic) approaches to make decisions. When the two approaches are used together, the fundamentals tend to be how securities are selected (what to buy or sell), and technical indicators tend to be used to make judgements about when to buy or sell.

Technical indicators range from tools that are fairly easy to understand and that seem on the surface to be reasonable and logical and are widely used; to other tools that are very complicated, hard to understand and not widely used.

Getting back to the client question, “where is this market going?” Let’s look at a few technical indicators that are comparatively simple.

There are three really basic judgements you must make in the following order to use technical indicators beneficially:

  • FIRST: judge the direction of the primary trend
  • SECOND: judge whether the recent price behavior is in the direction of the trend (“pro trend”) or in the opposite direction of the trend (“contra trend”)
  • THIRD: judge the probability that the price position (whether moving with or against the trend) is high or low.

With those three opinions in mind, technically based decisions can begin to make some sense and possibly work out beneficially.


  • 10-week exponential moving average (solid red) = DOWN
  • 40-week exponential moving average (solid gold) = DOWN
  • 120-week exponential moving average (solid blue) = UP
  • 3-month linear regression direction (dashed red) = DOWN
  • 1-year linear regression direction (dashed gold) = DOWN
  • 3-year linear regression direction (dashed blue) = UP

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One could use shorter-periods, in fact day-traders probably use ticks, and minutes and hours; but for our purposes, we think 10-week and 3-month views are short enough; and the 40-week (equal to the 200-day average) and 1-year views are most important. We put in the 120-week and 3-year views to show that the current price is even below those long-term trend indicators.

We like the 40-week (200-day) and 1-year time-frame best for primary trend.

Our judgement is that the primary trend is currently DOWN.


  • The 63-day (3-month) moving average is below the 200-day moving average (primary trend indicator) – PRO TREND
  • The 21-day (1-month) moving average is below the 200-day moving average and the 63-day average – PRO TREND
  • The price is below the 21-day and 63-day moving averages – PRO TREND
  • The way the 63-day, 21-day and price are stacked reinforces the PRO TREND judgement

Remember, the primary trend is down, so pro trend is “pro down”.

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The upper panel of this chart plots price position measured in the number of standard deviations it is from the 200-day primary trend line. Zero, means the price is on the trend line. These are called “Z-scores” (see Z-Score graphic below the chart).

Z-Scores have these meanings:

  • Based on a normal distribution curve, the price has a 68% chance of being between -1 and +1 standard deviations (Z = -1 to +1), and only a 16% chance of being out side of that range on either side (about 6:1 odds that the price will revert back to within the 1 standard deviation range).
  • The price has only about a 2.5% chance of being outside of the +/- 2 standard deviation range (about 40:1 odds that it will revert back to within the 2 standard deviation range).
  • The price has only about 0.1% chance of being outside of the +/- 3 standard deviation range (about 1000:1 odds that it will revert back to the 3 standard deviation range)

In the upper Z-score panel in the chart below, the dashed red line is for Z=0 (price on the trend line). The two solid red lines are for the boundaries of the 2 standard deviation range (Z= +/-2). The solid black line is for the boundaries of the +/- 3 standard deviation range (the upper black line does not show because the price did not get to that level in the period studied).

The interpretation of this chart is that back in the August Correction, unless there was a material change in circumstances other than price, there was a statistical certainty of a rally.

The current price is 2.08 standard deviations below the primary trend line which suggests further rally is likely, BUT the primary trend is down. So while the rally would take the price higher it would be short-lived, because it is a Contra Trend move. The kinds of material changes in outside circumstances that could change the primary trend and take the rally to new heights might be something like Saudi Arabia reducing oil production or the Fed backing off of a March rate increase.

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Major index internal breadth is badly deteriorated and getting worse, not just for US stocks, but also for foreign stocks. Let’s look as some S&P 500 internal breadth data for the S&P 500. After the wild up and down week last week, the needle did not move much on breadth.

  • Median S&P 500 stock off its trailing 1-year high by 20.68% (minimally improved) versus the S&P 500 index off by 10.76%
  • % of S&P 500 stocks in 10% Correction or worse 77.48% (versus 82.56% the prior week – some improvement, but 77% in Correction is not good)
  • % of S&P 500 stocks in 20% Bear or worse 51.12% ( versus 52.94% the prior week – minimally improved and not a good number)

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OK, let’s see what other tools might suggest for price targets and support and resistance levels given our three judgements:

  • Primary trend is down
  • Current rally is contra trend
  • Current price position relative to primary trend line indicates a higher probability of more transient contra trend rally than more pro trend decline (absent material external change in circumstances)

So what do some quantitative technical tools say about short-term price targets – specifically 3 months out?

This chart plots linear regression trend lines based on 1 year, 6 months and 3 months of history; and with a 3-month extension. Those trend lines intersect the price scale at 1975, 1985 and 1760 respectively.

The chart also plots “price probabiltiy ranges” (“probability cones”) out three months based on 1 year, 6 months and 3 months of history using historical volatility and a 70% probability. 70% probability is very close to the +/-1 standard deviations range we looked at in the Normal Distribution Curve above.

At the end of 3 months volatility-based price range projections (at 70% probability) we see prices between 2225 and 1795 based on 1 year history; 2250 to 1775 based on 6 months history; and 2045 to 1780 based on 3 months history. (see more about Linear Regression)

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Note that the probability cones are agnostic as to direction, but if we mentally apply the primary trend judgement, it makes sense to expect more action in the lower half of the probability ranges than in the upper half over the short-term.

Well, what about price levels that might possibly create some resistance in a rally?

This chart uses Fibonacci intervals to suggest price level and time periods where resistance might be expected if stocks behave in accordance with the Fibonacci pattern that is so common in life, and perhaps in financial markets (see these links for more about Fibonacci Arcs and Fibonacci Retracement).

Fibonacci tools plot distance between peaks and troughs that are divided into Fibonacci intervals, and some technicians believe that those intervals more often than not represent points where investors hesitate and create resistance on the way up and support on the way down.

The Fibonacci ARCs (blue) divide the vertical distance between peak and trough into Fibonacci intervals and then use those distances and the radius of the Arcs to suggest both price and date for resistance.

The Fibonacci Retracements (dashed red) simply divide the distance from peak to trough, but do not include a time element. One might argue that where the two tools intersect is a likely resistance point on the way up and support on the way down.

For better or worse those points are 1935 (38.2% retracement), 1975 (50% retracement – not a Fibonacci number, but a Dow Theory number) and 2015 (61.8% retracement) .

The peak was 2134 back in June 2015, and the trough was 1812 in January 2016.

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Another simple quantitative measure uses Price Channels (boundaries based on trailing high and low prices see more about Price Channels). Using the 63-day (3-month) and 21-day (1-month) Price Channels; and assuming that the mid-point of those channels are decision points for investors to be more Bullish or to hesitate, we see possible resistance at 1948 and 1968.

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Last, we might look at what are called Pivot Points, that predict possible support levels and possible resistance levels. explains the calculations nicely here:

  • First support level is 1800
  • Second support level is 1693
  • First resistance level is 2025
  • Second resistance level is 2145.

They call them Pivot Points, because those are possible prices where investors (or traders) collectively will likely turn on their heels and pivot to move back in the direction from which they came.

The resistance levels are labeled R1 and R2 on the chart; and the support levels are labeled S1 and S2 on the chart.

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