Small Caps Are Lagging. Investors Should Be More Concerned When They Lead

Summary:  SPX made a new all-time high (ATH) last week. DJIA and NDX were not far behind. And the broadest measure of the US stock market comprising 98% of stocks came just 0.1% shy of a new ATH.

By contrast, small caps are lagging. They have retained none of their gains made over the past 1-1/2 years and haven't been close to a new ATH in 10 months. Should investors be worried?

By most measures, the answer is probably not. Small cap underperformance has more often marked a low in SPX, not a high. Investors should be more worried when small caps - which are highly speculative and high beta - lead, as this has most often been a feature of major bull market tops, the reverse of the situation we have now.

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Last week, SPX made a new all-time high (ATH). The DJIA equalled its ATH from October 2018 and NDX came within 1% of its ATH from just last month. The broadest measure of the US stock market, the Russell 3000, which comprises 98% of stocks, exceeded its May high and came within 0.1% of its October 2018 ATH. By most measures, US stock prices are doing well. Enlarge any chart by clicking on it.

Interview With Financial Sense on Macro Risks and The Market Correction

We were interviewed by Cris Sheridan of Financial Sense on November 12th. During the interview we discuss the macro-economic environment, specific risks that are unfolding and current market technicals as stocks suffer their second correction in 2018. One theme of our discussion is what to look for over the next several months.

Our thanks to Cris for the opportunity to speak with him and to his editor for making these disparate thoughts seem cogent.

Listen here.

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What Today's Trend Following Sell Signal Implies For The Months Ahead

Summary:  With SPX closing below its 10-month moving average, a sell signal for a popular trend following system triggered today. This system has handily beaten the long-term performance of just holding SPX.

So what happens next? Using data from the last 38 years, there is an even chance that SPX reverses direction and moves higher from here over the months ahead. But the October low - or very close to it - appears likely to be retested in November.

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After rising every month for 6 months since the end of March, and in the process gaining more than 10%, US equities fell hard in October. SPX dropped 7%, NDX 9% and small caps 11%.

This was the third worst month since the bull market started 116 months ago in March 2009; only May 2010 (flash crash) and August 2011 (European debt crisis) were worse.

The fall was enough to trigger a sell signal in a popular trend following system.

Trend following dispenses with the debate about recessions, the actions of the Fed, corporate earnings, valuations, China, investor sentiment, market breadth, and all the rest. It focuses purely on price and implicitly assumes that it reflects the most useful information available.

How does it work? As described by Meb Faber here, investors stay long when SPX is above its 10-month moving average (MMA) at month end and move to cash when it closes below. That's it. The system's long term track record is excellent (red line), handily beating the SPX (blue line) and 80-90% of professional investors (more on that here). Enlarge any chart by clicking on it.

Emerging Markets Might Be Ready To Outperform

Summary:  Emerging markets equities have lagged in 2018 and throughout most of the last decade. Recent fund outflows have been extreme. Fund managers are underweight the region. Their currencies and commodities are not liked. The region is now "cheap" and it might be ready to outperform.

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2018 has been a tough year for emerging market equities. The index is down nearly 8% while the S&P is up more than 5% and US small caps are up 10%.   Enlarge any chart by clicking on it.

The Money Gods' Price For Achieving High Returns

Summary:  During their lifetime, most investors will likely endure another decade-long bear market like the ones in the 1970's and 2000's. Younger investors will probably suffer through at least two.

When thinking about the last 20 years, investors easily recall the tech bubble, the financial crisis and the flash crash in 2010 that together form the most recent lost decade for equities. These negative events dominate our decision making. The (more important) 300% return from equities during this time does not.

For all the time spent worrying about bear market risks, the overwhelming majority of short term traders and professional fund managers haven't found a way to avoid it. And if they have, it has been at the expense of also missing out on the gains during bull markets.

If you are going to do better than most, it won't be by continually anticipating a market crash. That has invariably been an exit ramp onto a dead end street. Tuning out noise and consistently following investment rules and hard data is far more challenging than it sounds, but the performance of those that who do it can be in the top 5%, maybe the top 1%.

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If you are in your 40's or 50's, you will probably endure another lost decade like the 2000's, where stocks did not appreciate on a net basis. If you are in your 20's or 30's, there's a good chance you will endure at least two such periods in your lifetime.

The future could turn out different than the past, but the pattern over the past 120 years is that expansions alternate with long periods where equity markets churn sideways. That's true even if you include dividends and assume dollar-cost averaging (DCA). The chart below shows the length of time US equities have spent getting back to breakeven from a peak (from Lance Roberts; read his recommended article here). Enlarge any chart by clicking on it.

Interview on Real Vision Television

We were interviewed on Real Vision Television on May 29th. During the interview, we discuss our long term equity market view, the current macro-economic environment and market technicals.

Our thanks to Real Vision for the opportunity to share our thoughts. Click here to become a subscriber.

To watch the interview, click here.

If you find this post to be valuable, consider visiting a few of our sponsors who have offers that might be relevant to you.

Separating an Innocuous Correction From the Start of a Sinister Bear Market

Summary: It's true that equities fall before the start of most recessions. So why bother following the economy; why not just follow the price of equities?

"Market corrections" occur every 20 months, but less than a third of these actually becomes a bear market. Recessions almost always lead to bear markets, and bear markets outside of recessions are uncommon.  For that reason, discerning whether a recession is imminent can help determine when an innocuous correction is probably the start of a sinister bear market. Volatile equity prices alone are not sufficient.

The future is inherently unknowable. We can never say with certainty what will happen in the month's ahead. But the odds suggest an imminent recession in the US is unlikely at present and, barring a rogue event like 1987, a bear market is not currently underway. That means equities are most likely on their way to new highs in the coming months.

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Why bother following the economy? Why not just follow the price of equities?

It's true that equities fall before the start of most recessions. Take the last 50 years as an example. There have been 7 recessions and the S&P has peaked and started to fall ahead of all except one (the S&P peaked with the start of the recession in 1990). On average, the S&P has provided a 7 month "heads up" that a recession is on the way. That's enough for even the slowest investor to get out of the way. Enlarge any chart by clicking on it.

Interview With Financial Sense on What To Look For Ahead of an Equity Market Peak

We were interviewed by Cris Sheridan of Financial Sense on March 13th. During the interview we discuss the macro-economic environment, the housing market, current market technicals and the financial performance of US companies. One theme of our discussion is what to look for ahead of the next bear market in US equities. Another theme is a potentially bullish set up for US treasuries over the next several months.

Our thanks to Cris for the opportunity to speak with him and to his editor for making these disparate thoughts seem cogent.

Listen here.

If you find this post to be valuable, consider visiting a few of our sponsors who have offers that might be relevant to you.

After a 10% Drop, Will Equities "V Bounce" or Double Bottom?

Summary:  Corrections during bull markets have had a strong propensity to form a double bottom. Since 1980, only 16% of corrections have had a "V bounce" where the low was never revisited.

The current bull market has been different. Since 2009, about half of the corrections have had a "V bounce." So what happens this time?

Sentiment can be reset through both time and price. It's a good guess that if price recovers quickly, sentiment will again become very bullish, making a retest of the recent low probable. A slower, choppier recovery will keep investors skeptical, increasing the odds that the index continues higher.

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Our weekend article summarized the outlook for US equities following the first 10% correction since early 2016 (read it here).  Prior swift falls of this magnitude have led to quick recoveries that eventually retested prior highs. That view is further supported by the washout in breadth, volatility and several measures of sentiment. Overall, risk/reward appears heavily biased towards upside in the near term. The strong rally today seems to support that view.

But our article also showed that while equities sometimes "V bounce", they more often form a double bottom as the strong down momentum is worked off over time.

This article provides 25 examples of roughly 10% falls in SPX over the past 38 years to demonstrate the strong propensity of the index to form a double bottom. We have not been a slave to the fall being at least 10% and we have deliberately excluded examples from the four bear markets where equities were clearly trending downward.

In the charts below, a red arrow is the initial 10% fall and the green highlight is the retest of the low in following weeks. 84% of the corrections have had a low retest (or a lower low).

There are 4 cases (16%) marked with a green arrow showing the initial 10% fall to also essentially be the low (a "V bounce").

While the "V bounce" has been rare, it's notable that 3 of the 4 cases since 1980 have taken place during the current bull market. If you just consider the past 9 years, the odds of a "V bounce" are a coin toss.

So which happens this time?

Sentiment turned very bearish during the past two weeks. It's a good guess that if equities now quickly recover, and if sentiment also quickly becomes very bullish, then a retest of the recent low is probably ahead. A slower, choppier recovery will keep investors skeptical, increasing the odds that the index continues higher. Enlarge any chart below by clicking on it.

1980-84.

What To Expect From Equities In 2018

Summary:  US stocks will likely rise in 2018. By how much is anybody's guess: the standard deviation of annual returns is too wide to get even close to a correct estimate on a consistent basis. Earnings growth implies 6% price appreciation, but tax cuts could boost that to 13%.  Investor psychology could push returns much higher (or lower).

While it's true that investors are already bullish and valuations are already high, neither of these implies a likelihood of negative returns in 2018. That the stock market rose strongly this year also has no adverse impact on next year's probable return.

A bear market is always possible, but is also unlikely. That said, the S&P typically experiences a drawdown every year of about 10%; even a 14% fall would be within the normal, annual range.  It will feel like the end of the bull market when it happens.

The Fed will likely continue to raise rates next year, which normally leads to higher stock prices. While political risks seem high, the stock market usually ignores these. The "Year 2" presidential cycle provides no investment edge.

This article highlights 11 key ideas to explain what to expect in 2018.

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Heading into the end of the year, investment pundits are beginning to share their expectations for how stocks will fare next year. All ten strategists polled by Barron's expect the S&P to rise in 2018, by a mean/median of 6-7% (full article is here; the next three charts from Barron's). Enlarge any image by clicking on it.

A Cautionary Signal After Today's Strong Gain

Summary:  US indices closed at new all time highs on Tuesday. The gain was so strong that SPX closed 25% above its Bollinger Band width. This is rare. There have been only 6 similar instances since 2003. None marked an exact short-term top in the market, but all preceded a fairly significant drawdown in the week(s) ahead. Risk-reward over this period was very poor.

There are a host of countervailing reasons to expect equities to end the year higher. This is only one data point, and the sample size is small. Nonetheless, a heads up is warranted.

In an addendum, we look at consecutive opens and closes above the upper Bollinger Band (there were 3 in a row this week). The message is the same: when SPY was not breaking out of a base, these instances have often been followed by at least temporary buyer exhaustion.

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Today, SPX, COMPQ, NDX, NYSE, DJIA and RUT all made new all time highs (ATHs).  The dominant trend remains higher. Enlarge any image by clicking on it.

The Flattening Yield Curve Is Not A Threat to US Equities

Summary:  On its own, a flattening yield curve is not an imminent threat to US equities. Under similar circumstances over the past 40 years, the S&P has continued to rise and a recession has been a year or more in the future. Investors should expect the yield curve to flatten further in the months ahead.

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Investors are concerned about the flattening yield curve. Enlarge any image by clicking on it.

Path To Higher Yields In 2018 Unlikely To Be Straight Forward

Summary:  Macro economic data is good. It seems likely that rates will be higher in a year and that suggests treasury yields will also be higher than they are now. But the path between here and higher yields is unlikely to be as straight-forward as is currently believed.

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Recent macro economic data in the US has been very good. In just the past month, retail sales have risen to new all-time highs, new home sales have risen to a new 10 year high and unemployment claims have fallen to more than a 40 year low. Last month, manufacturing notched an annual growth rate of 2.7%, the highest rate in over 3 years.

It would be sensible, therefore, to expect the Federal Reserve to raise its funds rate at its December 13th meeting; in fact, the implied probability of this is now close to 100%. Three further rate hikes are also expected in 2018.

Under this backdrop, investors would logically expect treasury yields to also rise.

That might well be the case, but the path is unlikely to be that straight forward.

Consider, first, that the Fed has already raised its funds rate 4 times in the past 2 years. Treasury yields were lower several weeks later every time. Enlarge any image by clicking on it.

Investor Psychology, Part III: Seeking and Avoiding Risk At Exactly The Wrong Time

Summary:  Too often, investors sell their winners early and hold on to their losers in order to avoid taking a loss. Put another way, when faced with a gain, investors avoid risk; when faced with a loss, they seek risk. It's the exact opposite of what a rational, profit-maximizing investor would be expected to do. This is another paradox of human behavior that helps explain why most investors perform badly.

Why do investors act in this way and how can this behavior be avoided?

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In a recent post, we described how prominent, but rare, events are mistakenly ascribed a high likelihood. Bear markets and crashes are objectively uncommon but feature prominently in our decision making. As a result, the average investor earns a return that is barely higher than the annual rate of inflation (that post is here).

To make matters worse, active investors engage in risk at exactly the wrong time, and avoid risk when they should instead be taking it.

 Imagine you are given the choice between:

a. $1 million guaranteed, or

b. A 50/50 chance to receive either $2 million or zero. 

The expected payoff of both options is the same, but most individuals choose a guarantee of $1 million (option a) rather than a chance to win $2 million. When faced with a gain, risk is avoided.

Now imagine you are given the choice between:

c. A certain loss of $1 million, or

d. A 50/50 chance of losing $2 million or losing nothing. 

The expected payoff is once again the same for both options, but this time most individuals avoid the guaranteed loss and favor gambling in order to breakeven (option d). When faced with a loss, risk is preferred (see note at the bottom of this page).

Investor Psychology, Part II: Following The Stock Market Is Bad For Your Returns

Summary:  The irony of equity investing is this: if you knew nothing about the stock market and did not follow any financial news, you have probably made a very handsome return on your investment, but if you tried to be a little bit smarter and read any commentary from experienced managers, you probably performed poorly.

The human mind has a tendency to assess risk based on prominent events that are easily remembered. The 1987 crash, the tech bubble, the financial crisis and the flash crash in 2010 are all events that are easily recalled. The mind automatically assigns a high probability to prominent (but rare) events. It ignores the more important "base rate" probability that better informs decisions. The fact that the stock market rises in 76% of all years, that it gains an average of 7.5% per year and that annual falls greater than 20% occur less than 5% of the time, are ignored in decision making. The mind interprets every 10% correction as the beginning of something much worse, even though a 10% fall is a typical, annual occurrence during bull markets.

Bearish market commentary that highlight risk conjure gravitas. Bullish commentary often seems shallow. But remember, in the absence of relevant data, the "base rate" probability is your best guide. Conflating prominent, but rare, events with high probability is an ongoing impediment to better investment returns. Recognizing this inherent deficiency in our decision making is perhaps the biggest potential source for improvement for most investors.

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In the past 12 months, the S&P has returned 22%. In the 3 years since the end of QE3, the total return is 37%. In the past 5 years, returns are over 100%.

Yet, throughout this period, investors with even a passing interest in financial news have regularly seen commentary from experienced managers that the stock market is highly likely to plunge now (from Daniel Miller). Enlarge any chart by clicking on it.

Investor Psychology, Part I: Using Time, Scaling and Inflation to Frame Data (and Mislead Readers)

Summary:  How data is presented has a significant affect on the conclusion a reader will draw. Behavioral economists call this framing: "what you see is all there is." Presented below is a mental trick used to mislead readers.

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Over the past 85 years, the S&P stock index has grown 35,600%. The rise looks parabolic. The conclusion appears to be that it is unsustainable (data from Robert Shiller).

Interview With Financial Sense on Identifying the Next Bear Market

We were interviewed by Cris Sheridan of Financial Sense on August 24th. During the interview we discuss current market technicals, the macro-economic environment, the investor sentiment backdrop and the prospect for future equity returns. One theme of our discussion is what to look for ahead of a bear market in US equities. Another theme is how the current period of low volatility will likely resolve.

Our thanks to Cris for the opportunity to speak with him and to his editor for making these disparate thoughts seem cogent.

Listen here.

If you find this post to be valuable, consider visiting a few of our sponsors who have offers that might be relevant to you.

This Is What A Bubble Looks Like: Japan 1989 Edition

Summary: Take the US tech bubble of the 1990s, add the subsequent real estate bubble of the 2000s, multiply by two, and you have a good approximation of the events leading to Japan's stock market crash in 1990.

The Nikkei stock index rose more than 900% in the 15 years before it finally topped. It was a frenzy powered by a belief that Japan Inc. was on its way to taking over nearly every major industry worldwide. The stock market bubble was further fueled by a massive real estate bubble at least twice the size of the one the US experienced in the 2000s. Tokyo alone became more valuable than all the land in the US.  In short, it was the product of a tsunami of monumental and concurrent events that are unlike anything present in the US today.

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Long advances in the stock market bring out fears that the rise will end in a crash. A current meme is how the US market today is just like the one leading up to the 1987 crash. That same argument was made in 2013, 2014 and 2016, and failed each time. More on that in a recent post here.

Today's stock market is sometimes compared to Japan's main stock index, the Nikkei, in the years leading up to its brutal crash in 1990.

Some might recall the Nikkei's spectacular advance. The index rose 30% in 1989 alone, but this came after a long bull market. Over the last 5 years of that bull market, the Nikkei rose 3.4 times; over the last 15 years, it rose more than 10 times. The rise was relentless.

Today Is Not Just Like 1987

Summary:  Today is not just like 1987.

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In 1987, the stock market crashed.

The Worry About Indexing is Overblown

Summary:  Investors are clearly shifting away from actively managed funds to those based on index strategies. Only time will tell, but this has the look of a durable, secular change in investment management. But much of the perceived threat to market stability of indexing is overblown. Overall, the stock market is still dominated by active management. And while the number of index products has clearly exploded, 96% of these are of insignificant size.

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Bloomberg recently reported that the number of indexes has exploded and now exceeds the number of stocks in the US.  Enlarge any chart by clicking on it.