S&P 500 Index 1927
By Steve Blumenthal
June 4, 2014
I favor a probability-based view towards risk. On Friday, I’ll update the most recent (updated through May month-end) valuation charts and share some data on inflation, current investor mutual fund/ETF holdings and margin debt.
Today, I include an early peak at one of the valuation charts. Valuations are high. It is from this perspective that I believe one can assess underlying risk.
While valuation is not a timing tool, it is a good measure of underlying risk and potential reward. When valuations are low, there is less risk and more reward. When high, more risk and less reward.
Included in this week’s Trade Signals:
- Cyclical Equity Market Trend: Bullish Trend for Stocks Remains
- Investor Sentiment: Crowd Sentiment Poll “Temperature Rising”
- Zweig Bond Model: Bullish Trend for Bonds Remains
- S&P 500 and Normal Valuation – 30% Overvalued Based on Dividends, Earnings, Cash Flow, Sales, PE and Trend (data back to 1920s)
- Additional Information along with Charts on Trend, Sentiment and Interest Rate Risk
Cyclical Equity Market Trend: Bullish Trend for Stocks Remains
See “How I Think About Big Mo” below.
Investment Sentiment 6-3-2014:
Sentiment Chart – NDR Crowd Sentiment Poll: Extreme Optimism (Hedge)
Crowd Sentiment Poll (my favorite sentiment indicator) is once again in the Extreme Optimism (Bearish) zone. Note red arrow and the poor historical equity market performance when the majority of investors are bullish.
The average value of the indicator at Extreme Optimism (1995 to present) is 68.2. The current reading is 68.9. The average reading at Extreme Pessimism is 46.7. The idea here is that one wants to be a buyer when everyone else is selling (Extreme Pessimism) and a seller when everyone else is buying (Extreme Optimism).
If you are a new reader, the gray area highlights the historical market performance when Investor Sentiment, as measured by Ned Davis Research, moves into the Extreme Optimism (Bearish) Zone (above the dotted black line or a reading of 66).
Daily Investor Sentiment too is nearing Extreme Optimism.
Zweig Bond Model: Remains a Bullish Signal for Bonds
See “How To Track The Zweig Bond Model” below.
S&P 500 and Normal Valuation – 30% Overvalued Based on Dividends, Earnings, Cash Flow, Sales, PE and Trend (data back to 1920s)
Note the poor returns when above 20 (Yellow Circle and Red Arrow). Valuation is not a timing tool like Big Mo. Valuation, in my opinion, is a measure of underlying risk and potential future reward. When low, less risk and more reward. When high, more risk and less reward.
Additional Information along with Charts on Trend, Sentiment and Interest Rate Risk
Additional favorable trend support can be seen in the following 13/34-week trend chart.
13/34-week EMA – The cyclical bull market’s uptrend remains in place. Note the blue 13-week EMA line remains above the red 34-week EMA line. Also note how well this simple, tactical trend indicator has historically captured the cyclical bull and bear market trends. Signals occur when the lines cross.
Interest Rate Trend, as measured by 13/34 week EMA, is lower for both the 30-year Treasury Bond and the 10-year Treasury Note (see blue dotted lines)
How I think about using Big Mo:
I like to think of Big Mo as a risk-timing tool. This is far different than market timing. The idea is to hedge the portion of your portfolio invested in equities against periods of major market risk. While no indicator is perfect and past performance guarantees you nothing in this business, Big Mo has done a good job identifying the major market trends. It is my favorite stock market trend indicator.
The orange box highlights historical performance. The yellow circle marks the last Big Mo trade signal.
The NDR Big Mo Multi-Cap Tape Composite Model was created to give a composite reading on the technical health of the broad equity market. The model uses trend and momentum indicators based on a broad array of our NDR Multi-Cap cap-weighted sub-industry group price indices. Trend indicators are based on the direction of a sub-industry’s moving average, while the momentum indicators are based on the rate of change of the sub-industry’s price index. By including many indicators together in the composite model, the process quantitatively analyzes the “weight of the evidence” regarding the market’s trend and momentum rather than relying on only one or a few indicators.
How To Track The Zweig Bond Model
The idea is to stay with the trend. Despite Wall Street analysts’ estimates for a yield north of 3% by the end of 2014 (which still may prove correct) rates have fallen – not risen. This model has been properly long bonds since late last year.
This is something you may want to consider as it relates to your bond exposure. The process is highlighted in the top left of the chart. There are five steps.
Here is how the tactical trend following model works:
- Score a +1 when the Dow Jones 20 Bond Price Index (index symbol $DJCBP) rises from a bottom price low by 0.6%. Score a -1 when the index falls from a peak price by 0.6%.
- Score a +1 when the Dow Jones 20 Bond Price Index rises from a bottom price by 1.8%. Score a -1 when the index falls from a peak price by 1.8%.
- Score a +1 when the Dow Jones 20 Bond Price Index crosses above its 50-day moving average by 1%. Score a -1 when the index crosses below its 50-day by 1%.
- Score a +1 when the Fed Funds Target Rate drops by at least ½ point. Score a -1 when the rate rises by at least ½ point. Score +1 if a buy and -1 if a sell.
- Score a +1 when the yield difference of the Moody’s AAA Corporate Bond Yield minus the yield on 90-day Commercial Paper Yield crosses above 0.6. Score a -1 when the yield difference falls below -0.2. Score it 0 for a neutral score between -0.2 and 0.6.
- Score up the sum total of steps 1 through 5 once a week (the chart below reflects Friday’s close calculations). If the total sum is +1 or higher, invest in a total bond market ETF like BND (Vanguard Total Bond Market ETF) or AGG (iShares Barclays Aggregate Bond Index ETF). If the aggregate score is -1 or lower, buy BIL (SPDR Lehman 1-3 Month T Bill ETF).
As reflected in the following chart, the annual gain per annum was 9.71% vs. a buy-and-hold gain of 7.12%.
The process was developed in the mid-1980s and remains the same since. The data goes back to 1967 with the Barclays Aggregate Bond Index to 1976 and the Ibbotson Long-Term U.S. Bond Index from 1967 to 1976. I intend to post this chart each Wednesday in Trade Signals. Over that stretch of time, the model has done a good job at enhancing return and reducing risk in rising rate environments (highlighted orange rectangle).
The bottom section of the chart shows the combined score of the model’s five measurements. A buy is generated on scores > 0 and a sell on scores < 0. The model remains in a buy signal. ETFs such as BND can be used to express the view.
I received a larger than normal number of emails asking if we can run this strategy in a SMA (managed account). The answer is that while I believe it is a solid investment process, we run several strategies on our managed platform that I believe are superior though, in my view, the process is sound.
As a quick aside: If you choose to trade following the Zweig model or any other process for that matter, there are several important questions to ask yourself: Do you have the time to follow the model every day? Do you have the infrastructure in place to trade across multiple accounts? Can you execute ETF trades with little market impact and trade for very low commission? Do you have the conviction and belief necessary to follow the process through both losing trades and winning trades? Can you stick to the process over time?
I have traded our high yield trend following strategy for more than 20 years. I can honestly say there were a few times in the early years I thought I was smarter than the process. I was usually wrong – the process right. Emotion and ego are strong forces. You have to eliminate them and stick to the process. No small thing. I frequently say that half the battle is having a sound process and the other half is having the discipline to stick to the process.
So if you don’t have the time and/or infrastructure then find some flexible bond funds and/or managed bond strategies. Many exist. Several are outstanding.
Concluding Thoughts
Despite relatively high valuations, the primary cyclical trend remains favorable. The cyclical trend remains positive as measured by Big Mo and the Fed remains supportive for now. Caution is advised as the cyclical bull is aged and investor sentiment is once again in the Extreme Optimism zone. I continue to expect a sizable summer sell-off and favor hedging your equity exposure and actively managing your bond exposure in a disciplined way (ie: Zweig bond model).
Please let me know if you have any questions. (See important disclosures below.)
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
Provided are several links to learn more about the use of options:
For hedging, I favor a collared option approach (writing out of the money covered calls and buying out of the money put options) as a relatively inexpensive way to risk protect your long-term focused equity portfolio exposure. Also, consider buying deep out of the money put options for risk protection.
Please note the comments at the bottom of this Trade Signals discussing a collared option strategy to hedge equity exposure using investor sentiment extremes is a guide to entry and exit. Go to www.CBOE.com to learn more. Hire an experienced advisor to help you. Never write naked option positions. We do not offer options strategies at CMG.
Several other links:
http://www.theoptionsguide.com/the-collar-strategy.aspx
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by CMG Capital Management Group, Inc (or any of its related entities-together “CMG”) will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities.
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Written Disclosure Statement. CMG is an SEC registered investment adviser principally located in King of Prussia, PA. Stephen B. Blumenthal is CMG’s founder and CEO. Please note: The above views are those of CMG and its CEO, Stephen Blumenthal, and do not reflect those of any sub-advisor that CMG may engage to manage any CMG strategy. A copy of CMG’s current written disclosure statement discussing advisory services and fees is available upon request or via CMG’s internet web site at (http://www.cmgwealth.com/disclosures/advs).