For most investors, 2018 is turning out to be a tough row to hoe. Suddenly, nobody is talking about global synchronized growth, low inflation, the benefits of tax cuts, and 20% earnings growth. No, all that is now so 2017. Now investors are focused on slowing global growth, rising rates, an overzealous Fed, a global trade war, plunging oil prices, a rising dollar, risk in the corporate credit markets, and de-FAANGing their portfolios.
However, all this negativity is a rather recent development. Recall that until the beginning of October, the 2018 investing game had been pretty simple. Buy U.S. stocks and focus on those popular momentum-oriented names. Easy peasy, right?
But as is often the case, just about the time everybody had figured out the game, everything changed.
So here we are; staring at just 25 trading days left in the year. The bottom line on this fine Monday morning is that most investors are focusing on the negative and fearing the worst. Gone is the hope that ongoing earnings growth will produce strong stock market returns for as far as the eye could see. In its place is the idea of "correcting" prices for the new normal. A "normal" that includes the word "slowing" in front of just about every bullet point in the market narrative.
A Lot Of Red Out There
In looking at the year-to-date returns of the various asset classes through Friday, the appropriate theme song for the year would be, Nowhere to Run. Take a look at the numbers below and you'll see what I mean.
View Chart Online
Man, that's a lot of red.
In fact, Ned Davis Research tells us that this could be the first year since 1972 that none of the top eight asset classes (U.S. Large Caps, U.S. Small-caps, International Developed, Emerging Markets, U.S. Treasuries, U.S. Aggregate Bonds, Commodities, and Real Estate) have produced a return of at least 5%. Nowhere to hide, indeed.
Diversification Isn't Helping
This means that diversified portfolios are struggling across the board. For example, the iShares Allocation series, which are ETFs designed to provide a well-diversified portfolio according to varying risk targets, all sport negative returns year-to-date. iShares Conservative Allocation Fund (AOK): -2.70%
iShares Moderate Allocation Fund (AOM): -2.86%
iShares Growth Allocation Fund (AOR): -3.81%
iShares Aggressive Allocation Fund (AOA): -4.49%Allow me to put this situation into perspective. Even in years such as 2008, a year when the U.S. was in a severe recession and a "60/40" portfolio lost -19.8%, there were positive returns to be found in some asset classes (U.S. Treasuries). And then in 1974, there were green numbers to be found in areas such as Commodities.What's The Answer?If we are indeed seeing a bear market unfolding here (personally I am still in the "correction" camp at this stage of the game), it is important to recognize that the world is different than it was the last time the bears came to call.Remember, in 2015-16, investors still had Global QE to count on. In fact, Mario Draghi effectively ended the "mini bear" when he announced in February 2016 that the ECB was willing to do whatever it took to keep things together (and it didn't hurt that Japan was already on the QE-to-Infinity bandwagon). This was the epitome of what is called the "Fed Put" - where central bankers cuts rates to bail out the markets whenever trouble arises.However, this time around, there is no QE to save the day (unless things get REALLY ugly, that is). No, we're actually experiencing the opposite as the U.S. Federal Reserve is now thoroughly entrenched in a quantitative tightening phase. Oh, and Jay Powell doesn't seem to be the kind of guy that is likely to bail out the stock market from a 10% pullback.My point here is that IF (note the use of capital letters) we are entering a full-blown bear market, then we should probably expect to see an old-school type of bear. A market that grinds lower until either the narrative changes or values become appealing. A market environment that takes time to play out.Next, I'm going to opine that IF the bears are going to stick around for more than a couple of months, then investors are likely to need more than old-school diversification to succeed. In short, a risk-management strategy - a strategy that has been largely out of favor for many years - may help to cushion the blow of a full-on bear.Game On For The Bears?Personally, I'm not ready to declare that a bear has begun in the U.S. I see the current action as a corrective phase that can be reversed by either (a) the Fed confirming they won't "overshoot" and will be "data dependent" in 2019, or (b) the declaration of a truce in the trade war with China. I'm of the mind that the market mood would improve dramatically if either of these events were to occur (and especially if both occur). Finally, I feel strongly that even if the bears do take control of the game for a while, we will NOT see a repeat of 2007-08 (i.e. a decline of more than 50%). No, I favor the "mini bear" scenario - where a cyclical downturn lasting 6-8 months occurs within an ongoing secular bull move.In any event, it is important to recognize that the game has changed and that staying flexible is likely the key to success going forward. Now let's turn to the weekly review of my favorite indicators and market models...
The State of the Big-Picture Market ModelsI like to start each week with a review of the state of my favorite big-picture market models, which are designed to help me determine which team is in control of the primary trend.
View My Favorite Market Models OnlineThe Bottom Line:
As a reminder, the purpose of this indicator board is to determine the "primary" trend of the stock market from a long-term point of view. During times of stress, it is important to keep the big-picture cycle in perspective. The message here continues to be that the secular bull remains intact.
This week's mean percentage score of my 5 favorite models declined to 64.5 (from 71.5%) while the median fell to 65% (from 75%). Finally, while the historical return of the S&P 500 given the current model readings pulled back a bit again this week, the overall reading remains swell above the average.
The State of the TrendOnce I've reviewed the big picture, I then turn to the "state of the trend." These indicators are designed to give us a feel for the overall health of the current short- and intermediate-term trend models.
View Trend Indicator Board OnlineThe Bottom Line:
The Trend board continues to be weak as the S&P, Dow Industrials, and NASDAQ all closed at new cycle lows on the weekly charts. The good news is the Cycle Composite points higher from now until the end of the year.
The State of Internal MomentumNext up are the momentum indicators, which are designed to tell us whether there is any "oomph" behind the current trend.
View Momentum Indicator Board OnlineThe Bottom Line:
The Momentum board has turned decidedly negative as a key longer-term indicator - the L.T. Volume Relationship Model - flashed a sell signal last week. The only potentially positive takeaway is that momentum may soon enter the "so bad that it's good" zone.
The State of the "Trade"We also focus each week on the "early warning" board, which is designed to indicate when traders might start to "go the other way" -- for a trade.
View Early Warning Indicator Board OnlineThe Bottom Line:
The "Early Warning" indicators tend to work best when "the stars are aligned," meaning that the various indicators and time-frames are all in the same spot. Unfortunately, this is not the case at the present time. However, the good news is that the indicators are moving in the right direction and could soon become aligned nicely for an end-of-year run.
The State of the Macro PictureNow let's move on to the market's "environmental factors" - the indicators designed to tell us the state of the big-picture market drivers including monetary conditions, the economy, inflation, and valuations.
View Environment Indicator Board OnlineThe Bottom Line:
The External Factors board continues to provide an excellent assessment of where things stand from a big-picture standpoint. Given the mixed picture here, the takeaway is that risk factors remain elevated and return expectations are subpar.
Thought For The Day:He who walks straight rarely falls -- Leonardo da VinciWishing you green screens and all the best for a great day,David D. Moenning
Founder, Chief Investment Officer
Heritage Capital Research
HCR Focuses on a Risk-Managed Approach to Investing
What Risk Management Can and Cannot Do<hr>ANNOUNCEMENT:
HCR Awarded Top Honors in 2018 NAAIM Shark Tank Portfolio Strategy CompetitionEach year, NAAIM (National Association of Active Investment Managers) hosts a competition to identify the best actively managed investment strategies. In April, HCR's Dave Moenning took home first place for his flagship risk management strategy.PRESS RELEASE<hr>DisclosuresAt the time of publication, Mr. Moenning held long positions in the following securities mentioned: AGG, DBC, EFA, HYG- Note that positions may change at any time.
Indicators ExplainedShort-Term Trend-and-Breadth Signal Explained: History shows the most reliable market moves tend to occur when the breadth indices are in gear with the major market averages. When the breadth measures diverge, investors should take note that a trend reversal may be at hand. This indicator incorporates NDR's All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 5-day smoothing and the All-Cap Equal Weighted Equity Series is above its 25-day smoothing, the equity index has gained at a rate of +32.5% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +13.3% per year. And when both are below, the equity index has lost +23.6% per year. Channel Breakout System Explained: The short-term and intermediate-term Channel Breakout Systems are modified versions of the Donchian Channel indicator. According to Wikipedia, "The Donchian channel is an indicator used in market trading developed by Richard Donchian. It is formed by taking the highest high and the lowest low of the last n periods. The area between the high and the low is the channel for the period chosen." Intermediate-Term Trend-and-Breadth Signal Explained: This indicator incorporates NDR's All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 45-day smoothing and the All-Cap Equal Weighted Equity Series is above its 45-day smoothing, the equity index has gained at a rate of +17.6% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +6.5% per year. And when both are below, the equity index has lost -1.3% per year. Cycle Composite Projections: The cycle composite combines the 1-year Seasonal, 4-year Presidential, and 10-year Decennial cycles. The indicator reading shown uses the cycle projection for the upcoming week.Trading Mode Indicator: This indicator attempts to identify whether the current trading environment is "trending" or "mean reverting." The indicator takes the composite reading of the Efficiency Ratio, the Average Correlation Coefficient, and Trend Strength models.Volume Relationship Models: These models review the relationship between "supply" and "demand" volume over the short- and intermediate-term time frames.Price Thrust Model Explained: This indicator measures the 3-day rate of change of the Value Line Composite relative to the standard deviation of the 30-day average. When the Value Line's 3-day rate of change have moved above 0.5 standard deviation of the 30-day average ROC, a "thrust" occurs and since 2000, the Value Line Composite has gained ground at a rate of +20.6% per year. When the indicator is below 0.5 standard deviation of the 30-day, the Value Line has lost ground at a rate of -10.0% per year. And when neutral, the Value Line has gained at a rate of +5.9% per year.Volume Thrust Model Explained: This indicator uses NASDAQ volume data to indicate bullish and bearish conditions for the NASDAQ Composite Index. The indicator plots the ratio of the 10-day total of NASDAQ daily advancing volume (i.e., the total volume traded in stocks which rose in price each day) to the 10-day total of daily declining volume (volume traded in stocks which fell each day). This ratio indicates when advancing stocks are attracting the majority of the volume (readings above 1.0) and when declining stocks are seeing the heaviest trading (readings below 1.0). This indicator thus supports the case that a rising market supported by heavier volume in the advancing issues tends to be the most bullish condition, while a declining market with downside volume dominating confirms bearish conditions. When in a positive mode, the NASDAQ Composite has gained at a rate of +38.3% per year, When neutral, the NASDAQ has gained at a rate of +13.3% per year. And when negative, the NASDAQ has lost at a rate of -11.24% per year.Breadth Thrust Model Explained: This indicator uses the number of NASDAQ-listed stocks advancing and declining to indicate bullish or bearish breadth conditions for the NASDAQ Composite. The indicator plots the ratio of the 10-day total of the number of stocks rising on the NASDAQ each day to the 10-day total of the number of stocks declining each day. Using 10-day totals smooths the random daily fluctuations and gives indications on an intermediate-term basis. As expected, the NASDAQ Composite performs much better when the 10-day A/D ratio is high (strong breadth) and worse when the indicator is in its lower mode (weak breadth). The most bullish conditions for the NASDAQ when the 10-day A/D indicator is not only high, but has recently posted an extreme high reading and thus indicated a thrust of upside momentum. Bearish conditions are confirmed when the indicator is low and has recently signaled a downside breadth thrust. In positive mode, the NASDAQ has gained at a rate of +22.1% per year since 1981. In a neutral mode, the NASDAQ has gained at a rate of +14.5% per year. And when in a negative mode, the NASDAQ has lost at a rate of -6.4% per year.Short-Term Overbought/sold Indicator: This indicator is the current reading of the 14,1,3 stochastic oscillator. When the oscillator is above 80 and the %K is above the %D, the indicator gives an overbought reading. Conversely, when the oscillator is below 20 and %K is below its %D, the indicator is oversold.Intermediate-Term Overbought/sold Indicator: This indicator is a 40-day RSI reading. When above 57.5, the indicator is considered overbought and when below 45 it is oversold.Mean Reversion Model: This is a diffusion model consisting of five indicators that can produce buy and sell signals based on overbought/sold conditions.VIX Indicator: This indicator looks at the current reading of the VIX relative to standard deviation bands. When the indicator reaches an extreme reading in either direction, it is an indication that a market trend could reverse in the near-term.Short-Term Sentiment Indicator: This is a model-of-models composed of 18 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from a short-term perspective. Historical analysis indicates that the stock market's best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.Intermediate-Term Sentiment Indicator: This is a model-of-models composed of 7 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from an intermediate-term perspective. Historical analysis indicates that the stock market's best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.Long-Term Sentiment Indicator: This is a model-of-models composed of 6 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from a long-term perspective. Historical analysis indicates that the stock market's best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.Absolute Monetary Model Explained: The popular cliché, "Don't fight the Fed" is really a testament to the profound impact that interest rates and Fed policy have on the market. It is a proven fact that monetary conditions are one of the most powerful influences on the direction of stock prices. The Absolute Monetary Model looks at the current level of interest rates relative to historical levels and Fed policy.Relative Monetary Model Explained: The "relative" monetary model looks at monetary indicators relative to recent levels as well as rates of change and Fed Policy.Economic Model Explained: During the middle of bull and bear markets, understanding the overall health of the economy and how it impacts the stock market is one of the few truly logical aspects of the stock market. When our Economic model sports a "positive" reading, history (beginning in 1965) shows that stocks enjoy returns in excess of 21% per year. Yet, when the model's reading falls into the "negative" zone, the S&P has lost nearly -25% per year. However, it is vital to understand that there are times when good economic news is actually bad for stocks and vice versa. Thus, the Economic model can help investors stay in tune with where we are in the overall economic cycle. Inflation Model Explained: They say that "the tape tells all." However, one of the best "big picture" indicators of what the market is expected to do next is inflation. Simply put, since 1962, when the model indicates that inflationary pressures are strong, stocks have lost ground. Yet, when inflationary pressures are low, the S&P 500 has gained ground at a rate in excess of 13%. The bottom line is inflation is one of the primary drivers of stock market returns.Valuation Model Explained: If you want to get analysts really riled up, you need only to begin a discussion of market valuation. While the question of whether stocks are overvalued or undervalued appears to be a simple one, the subject is extremely complex. To simplify the subject dramatically, investors must first determine if they should focus on relative valuation (which include the current level of interest rates) or absolute valuation measures (the more traditional readings of Price/Earnings, Price/Dividend, and Price/Book Value). We believe that it is important to recognize that environments change. And as such, the market's focus and corresponding view of valuations are likely to change as well. Thus, we depend on our Valuation Models to help us keep our eye on the ball.<hr>DisclosuresThe opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program. Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided. Mr. Moenning may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Positions may change at any time. The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed. Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.