Market insights and analysis

How dynamic, risk-managed investment solutions are performing in the current market environment

4th Quarter | 2020

Market insights and analysis

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Updates on how dynamic, risk-managed investment solutions are performing in the current market environment.

By Jerry Wagner

The major stock market indexes finished higher last week. The Dow Jones Industrial Average gained 0.6%, the S&P 500 Index rose 1.9%, the NASDAQ Composite climbed 4.2%, and the Russell 2000 small-capitalization index increased 2.2%. The 10-year Treasury bond yield and its price ended the week essentially flat. Last week, spot gold closed at $1,855.61, up $27.16 per ounce, or 1.5%.

Stocks

Stocks continue their surge higher since the March pandemic low. There have been only two brief sojourns down into underbought territory: one in September and one in November. Both times, equities quickly recovered and soon returned to overbought status. At the highs in February, August, and October, we saw prices quickly revert to their mean and then some. But back in June and now since November, stocks have been able to hold on despite their overbought status and move steadily into higher ground.

As I have said many times, stocks can remain overbought for much longer than the financial media gives them credit for. One has to be careful not to sell too soon and miss out on all the fun.

At the same time, when stocks ascend into the financial stratosphere, as is presently the case, it is critical that we remain diligent for air pockets that can send prices quickly lower. And once that descent begins, one needs to know whether a parachute or simply a safety belt is what is needed.

As is always the case, the broad array of indicators that are available to us are mixed in how they paint the outlook. The trend remains our friend, and so is the Federal Reserve, which continues to support the markets with planeloads of cash.

Recent economic reports have generally been better than expected. Markit’s flash PMI report last week informed us that U.S. manufacturing, declared to be irretrievably in decline four years ago, surged to the highest level since May 2007! As has been the case for months, housing industry statistics, aided by low interest rates and substantial consumer cash reserves, continue to expand.

Still, there can be too much of a good thing. With too much candy, the tummy can start to ache fairly soon after ingestion. Currently in the economy, earnings analysts and company insiders are all projecting substantial earnings outperformance as we move into the fourth-quarter earnings reporting season. But as we have pointed out before, when guidance and earnings estimates are high, the likelihood is disappointment, and that can lead to falling stock prices. 

Probably of the most concern in terms of the stock market is the level of investor euphoria. Every measure of optimism by investors, including the Citi Panic/Euphoria chart below, is at or near all-time high levels.

High levels of investor optimism often lead to market corrections. A few weeks ago, I reported that the number of S&P 500 stocks that were at or above their 50- and 200-day moving averages was at the level where a correction could commence. This is not an immediate sell signal because, like overbought levels, the market can sustain them for a long time. But as is the case with overbought indicators, when the percentage of stocks starts to tumble, red lights do begin to flash.

This week the number of S&P 500 stocks above their 50-day moving average fell below the 70% level. In the past, this has meant stock price weakness over the next month. So far, the percentage of such stocks above their 200-day moving average has only breached the 90% level, which has led to mixed results in the past.

A new indicator that attracted my attention on SentimenTrader.com was the gamma/NYSE volume indicator that shows the amount of stock sales that options dealers must make to hedge risk as the market gains ground. Right now, we are at extreme readings. In the last few years, such levels have preceded a number of our corrections.

As Sergeant Esterhaus from “Hill Street Blues” used to say to his people before they left the precinct, “Let’s be careful out there.”

Bonds

As I explained a few weeks ago, Treasury yields were about to start to rise as they repeated a rising and falling pattern that extended back to August. Yet even as they created this narrow band of values, it can’t go without noticing that the band consistently is marching higher. Although we have now started the contraction phase again, where we should see yields fall and prices rise for a few days, the bottom of the yield band is closing in and a reversal to the upside is probably not far away.

Of course, the primary reason for the seemingly relentless rise in rates (and the resultant fall in bond prices) is the stimulus action of the Fed and the fear that inflation may not be too far behind. As we will likely find out at this week’s Federal Reserve Board of Governors meeting, there is no reason to believe that the Fed will decrease its support (of course, if it does, bonds will rally and stocks will probably plummet).

Gold

I remember well when Nixon closed the gold window in 1971. I had just completed my first year of law school and was trying to travel Europe on a budget for two of $5 to $10 per day. That day, I suddenly found that my small cache of American Express checks had shrunk in value by 20%. Fortunately, there were not that many days of touring left at that point!

As the chart above illustrates, the price of gold has increased 4,600% since that day in August 1971. It soared 385% in just the first six years after President Ford signed a bill allowing Americans to own gold privately for the first time since the 1930s.

While gold delivered fine returns last year, outperforming the S&P 500, lately it has not continued those gains. Since August, gold prices have been flat to down. Last week’s gains were welcome, but gold will continue to face headwinds as long as interest rates are rising. It needs a falling dollar and rising inflation to be able to buck the interest rate trend and move to new highs.

Flexible Plan is the subadvisor to the only U.S. gold mutual fund, The Gold Bullion Strategy Fund (QGLDX), which seeks to track the daily price changes in the precious metal.

The indicators

The short-term trend indicators for stocks that we watch are mixed. The very short-term-oriented QFC S&P Pattern Recognition strategy’s equity exposure has maintained its inverse (short) exposure to the S&P 500 Index, while all of the other short-term measures I monitor personally remain at least marginally bullish.

Our Political Seasonality Index (PSI) issued a sell signal Monday, January 25, at the close. (The PSI is available post-login in our Weekly Performance Report section under the Domestic Tactical Equity category.) 

Still, our intermediate-term tactical strategies are uniformly positive, although to varying degrees. The Volatility Adjusted NASDAQ (VAN) strategy has a 140% exposure to the NASDAQ, the Systematic Advantage (SA) strategy is 137.5% exposed to the S&P 500, our Classic strategy is in a fully invested position, and our QFC Self-adjusting Trend Following (QSTF) strategy remains 200% invested. VAN, SA, and STF can all employ leverage—hence the investment positions may at times be more than 100%.

Among the Flexible Plan Market Regime indicators, our Growth and Inflation measure shows that we are in a Normal economic environment stage (meaning a positive monthly change in the inflation rate and positive monthly GDP reading). This occurs about 60% of the time and favors gold and then stocks over bonds, although gold carries a substantial risk of a downturn in this stage.

Our Volatility composite (gold, bond, and stock market) is now showing a Low and Rising reading, which favors gold returns over stocks and then bonds. This stage occurs about 27% of the time and is represented by decent returns for all asset classes.



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