“All knowledge resolves itself into probability.” – David Hume
Bottom Line: I’m still bullish longer-term and there are some stocks I absolutely love over the next 6-12 months, but my feeling is it will require some patience before these stocks and the broader market make it easier for us again. Our Primary Trend Indicator turned positive on Friday, only to turn back down again yesterday. This is not a normal occurrence and has never happened before. It speaks to the heighted levels of volatility in stocks this year. This too shall pass.
What investors need to know now.
As I was writing this note earlier this week, I was going to use the term “Awash in Liquidity, so Why Am I Still Nervous?” Given the volatility in markets this week, that seems less insightful. Despite the fact that our Primary Trend Indicator (PTI) took a big jump into Bullish status last week, a few things still made me uncomfortable with the short-term prospects for the market. Our PTI has historically been smarter than I am and a fantastic tool to confirm growing or rising market risk. I’m beginning to wonder if the fact that it took this long to turn positive off the March lows may make it look even smarter.
This isn’t science. Well it’s not just science. In almost every system that ever existed, there is some human element. Even the most successful investment systems in the world will have humans running various tests on them over the years to see if markets still conform to the system parameters.
Our position remains that there are clear indicators that we can read which tell us when risk is going up or down. As smart as the PTI is, we continue to run screens on it and the markets to see if the diagnostics are running well. Markets change. The massive increase of passive investment vehicles like Exchange Traded Funds for example, can change the way money flows under the surface. To a large degree, that is what our PTI measures, how much money is flowing, and where.
But there is no golden rule or silver bullet which tells us when the market will go up and down, so over the years, as we built the PTI, we’ve also looked for complementary systems to verify that the PTI diagnosis is correct. One of the two largest components of The Schenk Group’s backup diagnostic system is Ned Davis Research Asset Allocation Models. Having warned investors very close to the top of the 2000-2002 AND the 2007-2009 US bear markets, their comprehensive and objective perspective is always worth checking in on to see if our own models (PTI+) need checking on.
The second component to our backup diagnostic system is a Money Flow Monitor (MFM). While our PTI measures where money is going, the MFM adds another perspective and measures the power of the money moves.
An echocardiogram is a test that uses ultrasound to show how your heart muscle and valves are working. The sound waves make moving pictures of your heart so your doctor can get a good look at its size and shape. You might hear them call it “echo” for short. This is like our PTI.
An electrocardiogram (ECG) is a test that checks how your heart is functioning by measuring the electrical activity of the heart. With each heart beat, an electrical impulse (or wave) travels through your heart. This wave causes the muscle to squeeze and pump blood from the heart. This is like the Money Flow Monitor.
An Angiogram uses X ray technology to visualize the inside of blood vessels and organs of the body, with particular interest in the arteries, veins, and the heart chambers and can be considered very much like the Ned Davis Research Asset Allocation Model.
I’m really starting to like this whole analogy thing, partly because it works so well. These three tests are used to monitor heart valve and artery disease, to see if blood is flowing and how freely, and to see how well medical or surgical treatments have been working and to see if more work needs to be done. Together, they can tell a lot about what next steps are needed to keep risk under control, and to get the best out of the patient, Mr. Market.
In The Markets
The “Echocardiogram”, our PTI gave a very positive reading last week, and maybe this is where the analogy weakens a bit, but the point is the same. It weakens because I don’t think what happened to the stock market this week is a normal outcome for an ECG, as the brief positive spurt of heart valve activity turned rather negative this week with some serious angina (doctors, ECG techs?) . As the S&P500 dropped over 6% on Thursday alone, it flipped our PTI back to a score of 4/9. It’s possible that the transition from Bearish (4/9 or lower) to Bullish (5/9 or higher) can involve a bit of noise so we’ll see how it resolves in coming days.
The problem comes when we look at the Electrocardiogram, as the electrical impulses in Mr. Market’s heart beat has remained weak even since the patient got out of bed at the market bottom in March. Historically when a patient is this far into recovery (the S&P500 bouncing 40%) we see much stronger activity in the heart-beat of the market. That is, if the patient will not need further hospitalization (another major market correction).
As mentioned I remain bullish longer-term and there are some stocks I absolutely love over the next 6-12 months, but my feeling is it will require some patience before these the environment becomes safe for Mr. Market to run on his own.
Why am I ultimately bullish?
Because for better or worse, Mr. Market is on so much medication that he almost can’t stay down forever. Again, the medication created long ago around the world but induced so aggressively on a global scale only since 2008 is money; money added to the system by the Federal Reserve buying bonds out of the banks, thereby increasing the banks reserves and their ability to lend. Money added to the system by the creation of new treasuries from the Treasury department and bought by the Fed, and money effectively added to the system by allowing governments to remain on the life-support of historic low interest rates.
Consider this chart from Tom McClellan at McClellan Financial Publications.
To keep this simple, the term Quantitative Easing, referred to in our business as “QE” is basically everything I just mentioned above. Quantitative tightening or “QT” is the opposite of everything I just mentioned.
Mr. Market recovered from his massive 2008 Coronary only due to the massive amounts of QE injected into his veins. You can see that every time they try to reduce the meds, angina kicks in and the paddles have to come out. They paused QE2 in 2011, just as European debt concerns caused a 20% correction in 2011. The market stabilized but then, in 2013 then Fed Chair Ben Bernanke only commented that they may “taper” the patient’s meds Mr. Market nearly had another attack. Using Bernanke’s vernacular, it became known as the “taper tantrum”. The doc reversed course, injecting more meds and Mr. Market began running again in 2013.
Stabilizing the medication drip in 2015 caused two coronary incidents as the market declined over 15% in summer 2015 and January 2016. The patient miraculously got out of bed, began to run in 2017. The doctors at the Federal Reserve believed the patient had come back to life and actually started reducing system liquidity going into 2018, causing one serious heart attack after another.
Given this week’s market action, the US stock market has not made much in the way of price gains since that time as shown in Chart 2.
Even including Dividends, the Toronto market has made zero returns.
McClellan’s Chart 1. shows just how much the Federal Reserve has responded which is effectively why I believe Mr. Market will again get up and start running at some point, even if right now his health is again suspect in the short term, like a patient requiring maybe another stent before he can go jogging again.
Tom’s article, “Don’t Tug on Superman’s Cape,” gets into more detail on the subject for those who would like some more reading.
What we really want to see to grow our money faster.
Equity market returns will often come in small periods. Periods of a few good years, and even good quarters within years. From 2012 – 2017 our equity portfolios came close to doubling. Since 2018 that rate of growth has been slower.
Here we’ll have a quick look at why that is and what we will see when my life becomes easier as Mr. Market’s arteries clear and our investment portfolio growth rates can pick up again.
My data doesn’t go back as far, so I’m borrowing this chart (Chart 4. ) from my friend Terence Brogan at Brogan Research. The chart below, while a little unclear shows the relationship between the equally weighted S&P500 and the regular S&P500. Just consider that the regular S&P500 is weighted by size of company and today, roughly speaking, five companies make up 20% of the entire S&P500. That is why looking at the S&P500 only doesn’t tell you how healthy Mr. Market is. Looking at the S&P500 only is like a doctor looking only at your face to see how healthy your heart is. That is why we use the ECG and EKG to see what is going on in Mr. Market’s arteries and heart valves.
Simply put, when the relationship is rising the average stock is outperforming, or doing very well. The arteries are clear and the heart is pumping strong. Although not very clear in this chart (I’ll produce a better one at another time) you will notice that every time the relationship weakened, and the average stock began to underperform (indicated by the Red declining lines on the chart) Mr. Market began to have health issues.
In the late 1990s, the only thing going up was technology. That was obvious and that of course did not end well with the big 50% bear market of 2000-2002.
The line declined significantly in 2007 ahead of the next 50% bear market in 2008. Even the European crisis causing a 20% stock market decline in 2011 saw the relationship weaken. Then going into 2015, as two major corrections happened leaving the stock market sideways for about 2 years was also preceded by the average stock underperforming the market. Then, the final declining red line which began in earnest in 2018 saw the average stock underperform the few big companies and the market go through ups and downs with a lot of sideways action since the beginning of 2018.
At some point this relationship will again improve and our average returns for that next few years at that point will probably go up a lot.
What can Inter-Market Behaviour Tell us About Our Ability to Grow our Retirement Accounts?
The basic premise of intermarket analysis is that there is both a cause and effect to the movement of money from one area to another. At Christmas time, people measure retail sales and their effects on retailers, if the Bank of Japan decides to push the Yen down by buying dollars it will push Japanese stocks higher, and when the US economy is strong, more money flows into items that are fun rather than just necessary. It is the latter comparison we will have a brief look at here, because frankly it reveals so much.
In the Mid ‘90s John Murphy, a pioneer in market analysis, wrote his first book on Inter-market analysis using an intuitive chart based approach which accelerated the area of study in the field of Technical Analysis.
Financial markets can seem very random or chaotic, but even chaotic systems can have certain undeniable patterns and the strength and direction of the relationship between two markets can reveal a lot about certain conditions. This relationship between fun businesses (Discretionary like TVs and sports cars) and necessary businesses (Staples like diapers and food) goods, and their related comparisons can tell us when odds of growing our retirement funds are better and when they are not as good. Let me show you how.
Let’s have a closer look at this simple yet powerful relationship.
In good economic times, some sectors do better than others. When things become uncertain, people stop traveling, stop buying big screen TVs, and stick to groceries and diapers (Consumer Staples). When times are good, sectors like Energy, Industrials and Basic Materials do well. When times are poor, Consumer staples tend to outperform.
Much like the Equal Weight comparison above, most sectors that do well in a growth environment have also been doing rather poorly relative to Consumer Staples since the start of 2019.
The iShares energy stock index below is charted relative to the Consumers Staples Index. in Chart 5. below, you can see that relationship really started to weaken early 2018, and the stock market as a whole (bottom pane) began to have trouble. Remember the bottom pane.
When the economy is growing and infrastructure projects are being built, basic materials (chart 6 below) like steel, aluminum and industrial chemicals do well. Similar to the energy sector, Basic Materials have been struggling, relative to diapers and groceries since early 2018.
In Chart 7. below you can see a similar relationship between Industrial stocks and Consumer Staples. It even tried to peak out of the downtrend this week, only to be slammed back down. People are buying food and paying utility bills, but not buying backhoes from Caterpillar.
Chart 8 below shows that small companies too have been underperforming the Consumer Staples sector over the same two-year period.
Simply put, when energy, discretionary stocks, industrials and smaller companies change their underperforming trend of the last two years, our job will become a little easier and the growth rate of your RSPs, RRIFs and other investments are likely to accelerate.
Reverting to a hockey analogy now, we’ll get some open ice and be able to break into the offensive zone and probably score some goals. Until then, we are battling it out in the corners and trying not to get scored on.
Since this counter-trend rally phase started March 24th we had not seen the market decline 3 trading days in a row until Thursday this week. The last time we saw the market declined three trading days in a row was the beginning of the Pandemic Crash, February 24th and then again into the final leg of the Pandemic Crash, March 9th.
Smart Institutional money is still very skittish and therefore my Money Flow Model has not turned positive and our Primary Trend Indicator turned positive for one day, then flipped back.
This too will change and there will come a time when Institutions jump in with both feet and maybe that is what we are seeing over the past three weeks but we need to see confirmation/follow thru to push our indicators. Until then, we are going to continue to sleep well at night keeping our stop losses tight and playing defense the best we can.
We remain completely open to any eventuality that the markets bring. Our strategies, tactics and tools will help us to successfully navigate whatever happens as we focus on monitoring supply and demand signals that the market provides us.
Have a very good weekend and we’ll be in touch with you soon.
Peter Schenk | Portfolio Manager, CMT, CIM
(778) 400-2810 E: email@example.com
Words we operate by:
“Deliver to the world what you would buy if you were on the other end. There is huge pleasure in life to be obtained from getting deserved trust. The way to get it is to deliver what you would want to see if you were on the other end.” – Charlie Munger
“Strive not to be a success, but rather to be of value.” – Albert Einstein