- In which direction should we be investing in the market?
- Are tailwinds behind this direction or are headwinds picking up?
Every Friday we publish a Weekly Market Summary with green, yellow and red lights on it. Green is good and red is bad. Everything on this site is in support of this market summary. The little tabs across the top of the site (trend, breadth, etc) mirror the different factors we follow to monitor the market. There is nothing here that doesn't fit with the methodology. Anytime you want to understand why a factor is red or green, click on the tab and read the accompanying analyses. To the fullest extent possible, we quantify and use empirics to determine the state of every factor.
Each factor discussed below.
Each factor discussed below.
Trend is the most important factor. We follow the 4 US indices, 9 sectors within $SPX, the cyclical index, bonds and ex-US markets and currencies to determine if the trend is up or down. Remember, "only price pays" and "the trend is your friend". There's only one problem with these mantras: Trend can change quickly and make you a bag holder, long or short, before you can say Jack is your uncle. It is probably the last factor to swing direction on the chart. Therefore, we need some signals to warn us when the trend may be likely to change.
Breadth is the second most important factor. A healthy market, not surprisingly, carries a great number of stocks higher. So, when a fewer number of stocks are moving higher, we should take notice. We like using McClellan oscillators NYMO and NYSI (which sums NYMO), NYAD and NYHL. At tops, breadth will often diverge from trend. This can persist for weeks (February 2012 as an example).
The factors below are headwinds, tailwinds and tea leaves. They should lead price. In an uptrending market, when these are red, its a headwind. In a downtrending market, when these are green, its a tailwind to propel a turning point. If you trade on these factors alone and ignore trend and breadth, you will likely incur large drawdowns.
Sentiment. We use that term broadly because within this category is hard data on whether fund managers are over- or under-weight equities, bonds and cash. Our leading indicator here is the monthly BAML survey. Low cash (near 3.5%) is an indication that investors are all-in. High cash (near 5%) means they are all-out. These are usually turning points. In June 2012, managers were all cash and this was a significant tailwind to higher prices. Put-call ratios are in here as well. AAII, II, NAAAIM all publish bull and bear surveys. We are only modestly happy with these; most work better at panic lows than euphoric highs. At the highs, watch for bulls to start to get out ahead of the price peak. These negative divergences are common. Everyone seems to think lower bulls at higher prices is a good sign; the evidence says otherwise. Sentiment is a good leading indicator of headwinds and tailwinds but extremes can persist for weeks.
Volatility. A Vix under 20 is associated with strong markets; above, and markets struggle. Vix can stay low for a long time but jump 50% of more during this period. Look for lower highs and higher highs to tell you that volatility is moving up. It will lead price changes (divergence). Another study we like is a move outside the Bollinger Band for a reversion to the mean. Remember, Vix usually moves opposite price.
Macro. You can endlessly debate whether the economy is improving or deteriorating and people with PhDs analyze the data much better than we can. What is valuable is to understand whether the economic data is meeting or failing versus expectations. Citigroup publishes their Citigroup Economic Surprise Index (CESI). It has a good track record of leading changes in indices. Look for divergences, as usual. A move below zero is bad, and vice versa.
Seasonality. There are 10 year, 4 year, annual, monthly and daily cycles. We plan to keep this simple and use monthly and annual cycles. November to April are the tailwind months; May to October are headwind months, but these are rough guidelines and change during the 4 year cycle and from year to year. Major opportunity to get creamed if you follow this too religiously.
Valuation. This should change very infrequently and in any case its a pretty rough timing mechanism. Markets tend to trade in a valuation band and can get over and under valued for longer than you can stay solvent, as Keynes would say (or did; he was actually referring to currencies). When investors get stuck in a bad trade they tend to talk incessantly about valuation. If we do, you know what's happened. We will look at EPS growth and compare that to valuation.
If you've read this far, we owe you a beer.
