HUGE INSIGHTS: The Big Picture - Issue #2
This is the second 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 first, 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.
Note: In order to gather some momentum, we are offering the first few issues of this publication for free. If you enjoy this newsletter, and wish to continue uninterrupted access to our work, please become a member by subscribing here.
Overview
The bull market appears to be in the midst of an interim topping process that may prove to be of some consequence going forward. The 2021 Cycle Composite topped on August 6th and has turned hard down into late October. Valuations are now historically extreme by almost every measure. If growth peaked in the second quarter, as we now suspect, then valuations are no longer supported by sequentially improving fundamentals. This condition, in combination with weak market internals and the complacent attitude of investors toward risk-taking, leaves us cautious toward equity market positioning during the seasonally weak August-September-October period, and potentially beyond.
The Cycle
The S&P 500 and the Nasdaq 100 both posted new all-time highs this week. The Dow Jones Industrial Average logged its all-time high on August 16th. We've been closely monitoring the 2021 Cycle Composite, an equally weighted model that aggregates the one-year Seasonal cycle, the four-year Presidential cycle, and the 10-year Decennial cycle for the S&P 500 index using data going back to 1928. The model line officially peaked for the year on August 6th and has since begun its rather sharp and steady decline into late October. YTD, the S&P 500 index has been tracking the model line with a correlation coefficient of > 90%. If it continues to track with the same tight correlation going forward, then we can expect the index to produce undesirable performance results during the 3-month period of Aug-Sep-Oct.
Historically, the 3-month period of Aug-Sep-Oct is the worst performing 3-month period of the calendar year. During this period, from 1928-2020, the S&P 500 index has produced an average performance of -0.03% and a median performance of 0.61%. In all, 55% of these periods were positive and 45% were negative. The best performance achieved during this 3-month period was 24.86%, which occurred in 1982. The worst performance produced during this 3-month period was -26.36%, which occurred in 1937. But, as illustrated in Table 1 below, when isolating the data to focus only on those Decennial cycle years ending in the number "1", the historical return statistics become far more concerning.
Valuations
Earnings growth has been nothing short of epic this year, outpacing Wall Street's estimates by the widest margin in the history of the data. As we wrote in our last issue, no analyst working on Wall Street under the age of 65 has ever witnessed GDP growth of this magnitude in their career. Therefore, few analysts, if any, were able to predict its impact on EPS -- hence, the massive upside earnings surprises in the first half of this year. In our opinion, the market has rallied as strongly as it has because experienced key decision makers at institutional investment firms have been correctly pricing in the effects of a more robust nominal GDP surge on revenue growth, and the reductions to corporate overhead on profit margins.
Fool me once shame on you. Fool me twice shame on me. Wall Street analysts may be young and inexperienced, but they're not stupid. Estimates for the rest of the year have been ramping up aggressively as the second quarter reporting season comes to a close. And with the impact of the "Delta" variant, higher inflation rates, an inevitable tightening of monetary policy on the immediate horizon, and the next expected round of fiscal stimulus tied up in Congress for debate, we think growth likely peaked in Q2, and big upside earnings surprises with it.
That being said, the sober John Hussman quote below has prompted us to take a deeper look at valuations through the most objective lens that we know – Total Market Cap-to-GDP, along with several other measures.
"It may be the greatest collective error in the history of investing to pay extreme multiples for extreme earnings that reflect extreme profit margins and extreme government subsidies, while imagining that those multiples also deserve a ‘premium’ for depressed interest rates that reflect depressed structural economic growth." ~ John P. Hussman, Ph.D. - President, Hussman Investment Trust - August 2021
To be sure, today's valuations are historically extreme. Total U.S. Market Cap-to-GDP is now 202%, a new all-time record high. That compares with its prior cycle high of 148% recorded in March of 2000. In addition, the Shiller Cyclically-Adjusted Price-to-Earnings (CAPE) ratio has reached 38.7x – more than double its historical average of 17.2x, and approaching its March 2000 record high of 43.8x. The S&P 500’s Dividend Yield at 1.3% is now challenging its March 2000 low as well, while its Price-to-Sales ratio has set a new all-time record high of 3.1x, exceeding the March 2000 cycle extreme of 2.0x by more than 50%.
Sentiment & Market Internals
The CBOE Options Put/Call ratio has long been considered to be a reliable contrary investor sentiment indicator. The lower the ratio, the more complacent investors appear to be in their risk-taking endeavors. While the Total Put/Call ratio (not pictured) has recovered from a low of 0.60 in January to 0.91 as of last week, when we compare the 'index' version of the data with the 'equity' version, we get the distinct sense that investors are getting a little nervous about the market, but they still love their favorite stocks!
Moreover, the extent of the market's internal weakness is concerning. The Nasdaq 100 and the Nasdaq Composite are leading the market's charge this week -- both have logged new ATHs, and both are outperforming the broader market. Below is a weekly chart of the Nasdaq Composite, an index made up of some 3300 stocks. It illustrates a substantial deterioration in the breadth of participation over the past six months. Indeed, the percentage of Nasdaq stocks currently trading above their 200-day moving average (considered by most to be representative of a stock's long-term trend) has posted a new 15-month low at just 37% -- down from a cycle high of about 81% achieved in February of this year. This glaring negative divergence explains that there is a heavy reliance by the major averages on just a handful of mega-cap tech and internet stocks, which dominate the indexes, in order to pull themselves up.
S&P 500 index internals appear just as feeble. Breadth contracted last week, pushing the 10-DMA of the percentage of net advancing issues to test the zero bound. Momentum, as measured by the 10-day RSI oscillator, is bouncing off last week's lows, but is again failing to confirm the new high in price this week, leaving a six-week-old negative divergence stubbornly unresolved. Finally, up volume has been waning since mid-July.
Market Analysis
While the market's trend still remains constructive, it's pattern appears to be terminal. Our preferred Elliott Wave count for the S&P 500 index above considers the entire move off the May 12th low to be a mature "Ending Diagonal Triangle" formation at intermediate degree of trend. This pattern only materializes in the final leg of an advance and signals a coming trend change (for more details on the rules and characteristics of this wave form click on the link: http://thepatternsite.com/EWDiagTriangle.html).
The count allows for additional upside potential to the upper boundary of the triangle at approximately SPX 4500 plus 1% (to account for a potential throw-over). Key support remains SPX 4370 +/- 3 handles. A sustained breach of key support would confirm this wave count and thus an important top for the S&P 500.
If we learned anything from the 2020 experience, it was to remain open minded about all of the possibilities until one becomes crystal clear. We illustrate three scenarios that we are currently entertaining below, labeled as follows: The Good, the Bad, and the Ugly.
The "Good" would best describe our top alternate count. It assumes a garden variety correction of at least 10%, before the market rallies to our long-standing target of SPX 4600.
Unfortunately, under our preferred count, the "Bad" appears to have the upper hand at the moment. Under this scenario, the market will fall short of our target and instead, log a more durable top, resulting in a much deeper corrective process.
As for the "Ugly," well there is no way to know for certain whether the Elliott Wave model extends beyond the Cycle degree of trend, but many practitioners have hypothesized the existence of a Super Cycle degree of trend. If it exists, then it would probably look a lot like the chart below.
One of the unalterable core tenets of the Elliott Wave Model is that five waves up are always followed by three waves down at the same degree of trend.
Top Actionable Trade Idea
One of the most effective equity hedge strategies that can be employed to protect capital is to go long Volatility Index (VIX) futures. By holding a long position in equities, investors are inherently short volatility. By going long VIX futures, an investor can potentially neutralize this effect and thereby protect capital.
The link below will take you to a white paper entitled, “VIX Futures and Options – A Case Study of Portfolio Diversification During the 2008 Financial Crisis,” published in the Journal of Alternative Investments by Edward Szado, CFA, in August 2009. It addresses the conclusions from research he conducted as a doctoral candidate at the Isenberg School of Management, University of Massachusetts, Amhurst.
The ProShares VIX Short-Term Futures ETF (symbol: VIXY) is a simple way for individual investors to take a position in the "daily performance" of the front-month VIX futures contract without entering into an actual futures transaction. The chart below indicates a level of $25, that once cleared, would raise the odds substantially that the VIXY is poised to rally strongly, and likely move inversely to the S&P 500 index as it has in the past.
Importantly, our readers should know that this idea is only designed as a hedge -- that is a 'trade' and NOT an 'investment.' It should be re-evaluated daily, based upon the prevailing market conditions. Also, be advised that the VIXY can move by multiples of the inverse percentage price change in the S&P 500 -- in both directions. Position sizing should be less than 10% of the portfolio, and profits should be harvested more quickly than usual. An initial stop-loss provision should be set at $21 or higher, according to your own maximum drawdown tolerance, and moved to breakeven once the trade has started to show credible progress.
Performance Review
On July 1st, in our inaugural issue, we suggested that the shares of the Fidelity Blue Chip Growth ETF (symbol: FBCG) looked attractive at $32.50. Today, it is trading at $33.90, +4.3% in less than two months. Our initial target was stated as $35, with a stretch target of $37. We now expect to hold for the initial target of $35, then take profits. We suggest raising stop-loss provisions to breakeven.
Conclusion
Our work concludes that the market is poised to top in the weeks immediately ahead. If this analysis proves correct, then it should be followed by a pronounced correction. Under the rubric of our current analysis, we believe the best course of action at this juncture is for investors to reduce their equity market exposure and raise cash levels until we are able to ascertain which of the above market scenarios has the best probability of coming to fruition. Alternatively, more experienced investors may opt to hedge their portfolios.
“There is a time to go long, a time to go short, and a time to go fishing.” ~ 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.
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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.