HUGE INSIGHTS: The Big Picture - Issue #1
Welcome to the inaugural issue of our new big picture investment newsletter designed to help traders and individual investors capitalize on thematic market opportunities that we uncover in our research using ETFs. Our methodology considers the underlying fundamentals, but also utilizes technical analysis, and employs systematic trend following techniques. Our goal is to educate our readers while helping them to generate consistent trading profits and manage risk.
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OVERVIEW
Our top-down analysis of economic conditions and market data leaves us constructive toward U.S. equities through the Summer months. Large-Cap Growth stocks appears poised to lead the way.
The S&P 500 and Nasdaq 100 indexes closed at new all-time record highs last week, while the DJIA and the Russell 2000 failed to confirm. The rotation away from value and cyclical stocks, and into growth and defensive issues helps to explain this bifurcation. The Dow is a price-weighted index that is heavily skewed toward the largest value stocks in the U.S., while cyclical sectors such as Financials, Industrials, and Consumer Discretionary account for 44% of the Russell index. Conversely, the Nasdaq is heavily populated with the largest growth stocks in the U.S., the top six of which account for nearly 20% of the S&P 500 index.
In our view, as the Technology and Communications sectors re-assert their leadership over Financials, Industrials, and the natural resource sectors, there will be a tendency for the value centric indexes to lag for a while. However, we fully expect the rising tide of a bull market to eventually lift all of the boats to some degree.
ECONOMIC GROWTH
The consensus of economists on Wall Street and at the Federal Reserve are currently forecasting real GDP to grow by 7.1% in 2021 and by 3.5% in 2022. We suspect that the the extra 0.1% behind the 7% handle for this year's growth forecast is just to let every on know that they have a sense of humor. We say that because it was just six months ago that the same cohort was forecasting just 4.5% growth for the current year.
We came into the year estimating a range of 7-10% growth for this year, and 5-6% growth for next year. We are currently published at 8.0% for 2021, and 5.7% for 2022. We expect to raise our current year estimate slightly once the second quarter GDP is reported, however, our 2022 estimate will remain unchanged until we get more clarification on the size and complexion of the infrastructure spending bill currently being negotiated in Congress.
Importantly, consensus estimates are still too low in our view, which means that Wall Street's EPS estimates are also still too low.
EARNINGS OUTLOOK
Back in business school, one of the most important academic lessons that we learned was that due to the money multiplier effect, each 1% of nominal GDP growth translates into about 3% aggregate revenue growth. The reason that we remember that, is because the man who taught our class was a guest lecturer by the name of Whitney MacMillan -- the former Chairman and CEO of Cargill, and he told us, "Don't ever forget that!" So we took it to heart.
Well, if old Whitney was right (may he rest in peace), and real GDP grows by at least 8% this year, then nominal GDP growth will equate to about 11%. Thus, aggregate S&P revenues should grow by around 33% in 2021. To put this into perspective, aggregate revenue growth for the S&P operating companies has averaged about 3.4% over the last 20 years. So, were looking at something like 10-times the average of the last two decades.
This explains why S&P operating companies have been blowing Wall Street consensus EPS estimates out of the water for the last two quarters. Just to be clear, in the first quarter alone, 87% of the constituents of the S&P 500 index beat consensus estimates by an average of 23%, reporting and aggregate of 52% y/y EPS growth. How is it possible for the street to be that far off the mark you ask? Well, nobody has ever seen revenue growth like this before -- ever!
Now, to make things even more interesting, profit margins are currently setting new all-time record highs. Why? Because, during the pandemic, companies were forced to cut their overhead down to the bone. As a result, they were also forced to implement new productivity measures that, in many case, have now become permanent. S&P 500 net profit margins have average 8.9% over the last 20 years. Today, they're 13.2%, or about 1.5-times the average of the last two decades.
So, if we assume that revenues grow at 33% this year, and net profit margins average 50% above the norm, then S&P operating EPS in 2021 could almost double the depressed $142 logged in 2020. Yet, the consensus estimate on Wall Street is just $189, up 33% y/y. By comparison, our published estimate for this year is currently $210, up 48% y/y, and takes into consideration peak growth in the 2nd quarter, a slightly lower average margin in the back-half, and a higher average tax rate for the year -- just to be conservative. But we are also contemplating raising our current year estimate in order to reflect a further increase to our 2021 GDP growth estimate, should the data support such a response.
MARKET ANALYSIS
The S&P 500 index (SPX) is currently trading at around 4300. By our work, the market has further upside potential to at least 4600 this year, with a stretch target of 4900. We think the SPX could reach our initial target by late August, with additional potential to reach our stretch target by year-end.
Our analysis considers several standard technical approaches to arrive at our initial target price. The first is an "equal swings" measure, which projects the initial rally from the March 2020 low to the August 2020 high, off the October 2020 low (blue arrows). That gets the market to SPX 4629. The second is a straight "measured move," which takes the depth of the base created by the decline from the February 2020 high to the March 2020 low, and projects it above the February 2020 high (red arrows). That gets the market to SPX 4594. Finally, we've employed some mathematical calculations based upon various Fibonacci ratios of the advance in order to identify key extension levels. The first level comes in at SPX 4663. Other levels project as high as SPX 4895.
None of these calculations guarantee that the market will achieve our target price, however, the principles of supply and demand upon which they are based have a long history of success. So, the probabilities favor this outcome. In addition, we have developed a market roadmap based upon the Elliott Wave principle. The wave principle is predicated on observed patterns of human social behavior and utilizes a framework employing the concepts of fractal geometry proposed by Benoit Mandelbrot, and mathematical proportions proposed by Leonardo Fibonacci. In short, human progress is achieved in fits and starts -- three steps forward, two steps back.
This is reflected in the price action of the stock market at every discernable degree of trend. These waves are observable as a series of five wave impulsive advances, with each bifurcated by a three wave corrective decline. As the degree of trend shrinks, the three wave moves become less discernable, but are nevertheless observable. The chart above presents the advance off the March 2020 low as an Intermediate degree five wave advance [1-2-3-4-5], with subdivisions at various lesser degrees of trend [i-ii-iii-iv-v and (i)-(ii)-(iii)-(iv)-(v)], all culminating toward the completion of a Primary degree trend [(5)] at one larger degree, and a Cycle degree trend [V] at two larger degrees.
Bottom line: 10,000 years of human evolution and the embedded psychology that drives our social behavior suggests that the advance is incomplete and will not terminate until the final subdivisions of the wave pattern are fully expressed.
SECURITY SELECTION
We recommend buying into strength and selling into weakness at the earliest point at which it can be confirmed. There are a number of tools that we employ in an effort to identify these critical points. The first is price action, the second is volume, the third is momentum, and last but not least is relative strength.
The late, great market strategist Paul Macrae Montgomery once wrote, "the most bullish thing that the market can do is go up." This concept applies to all asset classes, markets, sectors, industries, and individual stocks of every ilk. It is upon price itself that every other indicator is based. That fact, by itself, makes price action alone the single most important factor in the analysis of any security. There are good companies and there are good stocks. The two are mutually exclusive. Good stocks equate to the direction of their trend. An uptrend is defined as a series of higher highs, followed by higher lows. Stocks that are in an uptrend are good stocks.
Volume is the weapon of the bull. This fact was drilled into our head by a former colleague and mentor by the name of Louise Yamada, from back in our Citigroup days. The importance of volume is that it is instrumental in identifying a change in the character of the price action. When a stock or market goes up on a big volume increase, it suggests that there is institutional participation. Institutions don't get bullish or bearish per se, their customers do. When money flows into mutual funds, fund managers have to put it to work. They don't get to think about it and decide whether now is a good time to buy. That decision has already been made for them. They simply have to decide what to buy. And when they do, they tend to leave very big footprints behind.
The rate of change at which the price of a security or market index advances or declines is commonly referred to as its momentum. Momentum can be measured in a number of ways. It can be measured as an expansion of the daily volatility. It can be measured as a change in the deviation above or below a moving average. And it can be measured as a percentage price change over a specific period of time. Regardless of what method is used, of all the factors that have ever been tested, momentum has by far the greatest efficacy in terms of its predictive value.
By relative strength, we mean the relative performance between one security or index and another security or index. Why should this matter? If we buy a stock and it goes up, we make money. So, who cares what other stocks or indexes are doing, right? Wrong. Institutional investors are ranked based upon their relative performance to a benchmark -- usually the SPX. As such, institutions want to buy stocks that are outperforming the SPX. Therefore, we should want to buy stocks that are outperforming the SPX, so that we can benefit from the price moves created by the big volume buying of the institutions.
One common thread that links all of these factors is when a stock makes a new high. If you think about it, stocks that are making new highs are in an uptrend by definition. They are likely to be accompanied by good volume, good momentum, and in most cases, stocks that are making new highs tend to be leading the market. It takes buying pressure to push stocks out of a range and into previously uncharted territory. This characteristic is quite germane to our investment strategy.
In short, we want to focus our attention on stocks or indexes, or ETFs that represent the same, that are making new highs. Our preference is for new all-time highs. Why? Because there are no unhappy shareholders. There is no overhead supply. And thus, there are no natural sellers. In the absence of a new all-time high, we will consider stocks and indexes, or ETFs that represent the same, that are making new 52-week highs. The former tends to emerge from a pattern known to market technicians as a "bullish breakout." The latter, from a pattern known to market technicians as "bullish reversal."
PORTFOLIO POSITIONING
Identifying the best trading opportunities always begins with running a well-defined market scan. We use StockCharts Pro, which is a cost effective, cloud-based stock charting and screening platform with very dependable data. Using their Advanced Scan Workbench, we are able to easily screen through 10,000 securities, to narrow down the field to high probability trading candidates that meet our criteria -- in this case, ETFs traded on U.S. exchanges that are making new all-time highs. Below are the results including the formula for the scan:
There are 17 ETFs that fit our criteria. Now that we have some viable candidates that are suitable for investment, the next step in the process is to evaluate them based upon their relative strength (RS) compared to the SPX -- our benchmark. Using a Relative Rotation Graph, a data visualization tool on the StockCharts Pro platform, we are able to see how all 17 of these ETFs compare to the benchmark, and each other, simultaneously, as measured on both an RS ratio basis and by the momentum of their respective RS ratio -- the second derivative of RS. As we are always seeking out durable intermediate-term trends, the RS study below was set to a 30-week look back period.
Those securities which fall to the right of the vertical axis have a positive RS-Ratio and are therefore outperforming the benchmark over the 30-week lookback period. Those which fall to the left side of the vertical axis have a negative RS-Ratio and are therefore underperforming the benchmark over that period. In addition to the RS-Ratio, we can further observe RS-Momentum; that a security is in position to see its RS-Ratio potentially improve if it is above the horizontal axis, or that a security is poised to lose its relative advantage if it is below the horizontal axis.
This analysis allows us to quickly identify a theme and elevates several interesting securities to the top of the heap. The theme is that the Large-Cap Growth ETFs appear poised to move into the leading quadrant soon. We can also eliminate several choices as well including those ETFs that are crowding around the origin, and those that are either far left of the vertical axis, or far south of the horizontal axis. But when we consider only those remaining equity ETFs that rank > 97% on their RS-Ratio and > 99.5% on their RS-Momentum, then the selection becomes even more clear.
Looking at the 4-week percentage price change column on the right side of the table below, it becomes obvious that the momentum of the Large-Cap Growth ETFs has turned sharply higher and is outpacing the rest of the pack. Indeed, it is the Fidelity Blue Chip Growth ETF (FBCG) that is the true leader.
This calls for a close examination of the chart of FBCG to see if we can identify anything about the price action that will allow us to project an upside profit target.
Looking over a 1-year weekly chart, we can observe that price has broken out above the upper boundary of a classic lateral consolidation pattern known to market technicians as a "symmetrical triangle" formation. While volume isn't an important consideration when looking at a mutual fund/ETF, it is noteworthy to point out that price did challenge resistance and subsequently breakout on above average volume late last week, which is also supportive of the bull case.
From this pattern we can project several measured price objectives. First, an initial target of $35 can be calculated by projecting the depth of the triangle at its widest two points from its apex. Secondarily, a stretch target of $37 can be calculated by further projecting the depth of the triangle from it's peak. Finally, a longer term "equal swings" target of $40 can be calculated by projecting the distance of the advance from the June 2020 low to the February 2021 high, off the May 2021 low. So, with price trend, volume, momentum, and relative strength all supportive of a long position in FBCG, how much should we buy?
POSITION SIZING & RISK MANAGEMENT
There are several risk variables to consider before determining your position size. First and foremost is the maximum adverse excursion (MAR) or the absolute dollar amount that you are willing to lose if the trade goes south. We've created an example below, whereby we invest the capital of a hypothetical investment account with a beginning balance of $100,000. We also assume a MAR of 1%, or $1,000 based upon that beginning balance. We also assume a net entry price $32.60 per share and a target price of $37 per share. Next, using StockCharts Pro we calculate the average true range (ATR) for FBCG to be $0.41.
This ATR is an idiosyncratic volatility measure that is specific to FBCG. In order to be assured of losing no more than 1% of our original account capital, we will set our stop-loss at a price that is three ATRs below our entry price. Why three ATRs and not two or four? Because three times the average daily volatility of a relatively low volatility security is usually enough to make sure that you don't get stopped-out by the day-to-day noise, but not so much that you would incur a sizable percentage decline before your risk management discipline forces you to exit the trade.
As such, our stop-loss provision is assumed to be $31.37 per share. Under this rubric, our downside is capped at 3.77% and our potential upside is estimated to be 13.50%. The ratio of these two potential outcomes establishes a positive risk skew of 3.58:1. Our discipline requires a minimum positive risk skew of 3:1 in order to justify the risk of taking a position in a security. So, this brings us back to our original question: How much should we buy? Well, based upon our hypothetical $100,000 investment account, no more than 813 shares. Otherwise, 26.50% of your risk capital.
CONCLUSION
Our work concludes that the market is set-up for a rally that could last for the next 6-8 weeks. If our analysis proves correct, then we think our initial target of at least SPX 4600 (+7.2%) is achievable within that timeline. Large-Cap Growth stocks, including those that constitute the FAANG + index, appear poised to lead the charge. It is conceivable that they could strongly outperform the benchmark over that period. Our security selection process has identified the Fidelity Blue Chip Growth ETF (FBCG) as potential leader within that space. Based upon the analysis above, we believe FBCG represents an attractive way to position for a potential Summer rally.
"Markets are never wrong, but opinions often are. Watch the market leaders." ~ Jesse Livermore
DISCLAIMER
All information and data contained on this site and in reports, analytics, etc. produced by Jeffrey W. Huge (the “author”) is for informational purposes only. The author makes no representations as to accuracy, completeness, suitability, or validity, of any information. The author will not be liable for any errors, omissions, or any losses, injuries, or damages arising from its display or use. All information is provided AS IS with no warranties, and confers no rights.
External links are often provided within the author's newsletter for the convenience of the reader. The author will not be responsible for any material that is found at the end of these external links.
The author is NOT registered as a securities broker dealer or investment adviser with either the U.S. Securities and Exchange Commission or with any state securities regulatory authority.
The content of the author's newsletter should not be considered professional financial investment advice. The ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional. The author may hold positions or other interests in securities mentioned, including positions inconsistent with the views expressed.
The user bears complete responsibility for their own investment research and should seek the advice of a qualified investment professional before making any investment decisions.
Past performance is no guarantee of future results.