Market insights and analysis

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

3rd Quarter | 2021

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 U.S. stock market indexes were generally higher last week. The Dow Jones Industrial Average gained 1.1%, the S&P 500 Index rose 1.7%, the NASDAQ Composite climbed 1.3%, and the Russell 2000 small-capitalization index picked up 1.1%. The 10-year Treasury bond yield gained 6 basis points to finish at 1.64%, sending bond prices lower for the week. Spot gold closed the week at $1,792.65, up $25.03 per ounce, or 1.4%.

Stocks

A wide array of indexes hit new all-time high points last week. Led by the S&P 500 Index, the equal-weight variety and the S&P 500 advance-decline line also made new highs. Such a combination in the past has not only suggested more new highs to come but has also substantially lowered the chance of a correction.

According to SentimenTrader.com, when this has happened “… there was only a 4.6% probability of a 10% or greater decline within the next few months and less than a 2% chance of a 20% decline. The S&P 500 can suffer a significant decline shortly after a breakout to a new high in the Advance/Decline Line. But it's exceptionally rare and comes quickly out of the blue. Since 1928, the only two instances were the Black Monday crash in October 1987 and the pandemic crash in March 2020.”

A good part of the reason for new highs has been the higher-than-expected earnings reported for the third quarter. The fact that so many companies are beating earnings and revenue forecasts in contrast to most pre-reporting prognostications has been encouraging the market higher.

The big test for third-quarter earnings, however, will come this week. The so-called FAAMG stocks (Facebook, Apple, Amazon, Microsoft, and Google/Alphabet)—which represent $9 trillion in assets under management, or about a quarter of the entire S&P 500 Index, and the top valuations of the NASDAQ 100—report earnings this week. When all five have reported in the same week in the past, results have been mixed and a short-lived index dip has occurred.

Focus on any particular economic index report has not been a key to recent stock market action. Instead, stories about inflation, labor shortages, and supply-chain disruptions have dominated the news, although to no avail when it comes to stock market prices.

The supply-chain issues have been particularly worrisome. While the president was not able to offer much hope on this at his town hall meeting, others have suggested some policy changes that seem to offer a way out and that the White House could get behind as possible solutions.

It should be noted that, as the chart at the top of this section demonstrates, stocks are in overbought territory and may be due for another dip. Valuations are now at higher levels than at the time of the tech correction in 2000, and consumer confidence has been at a short-term low by all measures, leading to speculation that future consumer spending and retail sales numbers could be in jeopardy.

Still, the next three months are an extremely bullish time of the year for stocks. COVID cases are declining, with most of the U.S. having achieved herd-immunity levels. And, finally, investor sentiment is only at middle-range numbers after bouncing decisively off the low levels registered just two weeks ago.

Bonds

Near the end of September, the government bond market plunged through its support and did not stop falling until mid-October. An attempted rally faltered in the ensuing week and a half. Then, a successful retest of the lows sent bonds higher until last week’s dip.

Most of the decline in bond prices can be blamed on the inflation news. None of the news has been good for the Biden administration, as measures of prices, wages, and shortages continue to suggest that inflation is anything but “under control.” As a result, the Federal Reserve’s comments early in the last quarter that inflation was going to be transitory do not seem to be bearing out.

The Fed is signaling that while it has no intentions of raising interest rates yet to try to stem inflation, it is likely to cut back on its bond-buying programs. This is the dreaded “tapering” of which so much has been written.

There is no doubt that the bond-buying program, together with the fiscal stimulus of both the present and the last administration, has created unprecedented liquidity that has been contributing to the inflationary pressures. This has positively impacted both the stock market and household pocketbooks. Last week, Fed bond purchases were over $80 billion! As to households, savings as a percentage of disposable personal income is at the highest level ever.

The combination of all of this liquidity and the (resulting?) inflation surge has led to very unappealing comparisons for bond investors. The rate earned on the 10-year Treasury bond after adjustment for inflation is now underwater (negative 4%), near all-time lows. Contrasting the bond’s yield to that of the S&P 500 dividend yield continues to favor stocks.

While the charts do not look good for government bonds, their high-yield cousins look closer to those of the stock indexes. They avoided setting new lows in October, broke through their 50-day-moving-average resistance levels, and are now once again bouncing higher with their underlying equities.

Gold

Gold has once again been in rally mode. Gold prices have been rising since late September. Earlier this month, they broke above their 50-day moving average and have stayed there.

This surge is not surprising. The U.S. dollar has been weakening throughout that period, and, as is usually the case, gold turned higher with the dollar’s decline.

The price action of both asset classes is a result of the same inflation news that has been punishing bonds. As the following chart demonstrates, core inflation rates have had an almost unprecedented surge higher. While the rate has not reached extreme levels, the sudden and substantial move higher in inflationary measures has frightened the financial world.

This could continue to prove supportive to gold prices. It could also put added pressure on the dollar should these soaring prices not abate.

Flexible Plan is the subadvisor to the only U.S. gold mutual fund, The Gold Bullion Strategy Fund (QGLDX), designed at its introduction more than nine years ago to track the daily price changes in the precious metal.

The indicators

The short-term-trend indicators for stocks that we watch are mixed. Our Political Seasonality Index has been in the market since October 14, but it signaled that investors should step aside at the close on Friday. After a week’s hiatus, the Index is suggesting a return to stocks this Friday (October 29). (Our QFC Political Seasonality Index—with all of the daily signals—is available post-login in our Weekly Performance Report section under the Quantified Fund Credit category.)

Our very short-term-oriented QFC S&P Pattern Recognition strategy, after being in stocks for much of the last two weeks, changed course in the middle of last week and is presently in a short position against the S&P 500. Some of our other short-term indicators are improving, suggesting that QFC S&P Pattern Recognition’s negativity may be short-lived.

FPI’s 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 90% exposed to the S&P 500, our Classic strategy is in a fully invested position, and our QFC Self-adjusting Trend Following (QSTF) strategy has an exposure of 200% invested. VAN, SA, and QSTF 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) has a High and Rising reading, with stock returns historically outpacing gold and then bonds. This stage occurs about 23% of the time and is the most volatile regime for all three asset classes.



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