The S&P 500 and Dow Jones Industrial Average both touched new records last week. I don’t know of a world in which new all-time highs are bearish. In fact, a quick historical study shows that healthy returns tend to follow new highs in prices. Nothing lasts forever though, so it pays to be aware of potential reversal indicators. And instances of one such indicator have added up in recent weeks.

The relative strength index (RSI) is a momentum oscillator created by J. Welles Wilder Jr. that measures the speed and magnitude of recent price changes. One of the most common interpretations of RSI is that a reading greater than 70 (on a scale of 0 to 100) indicates ‘overbought’ levels, signaling prices may be primed for a pullback. A reading below 30, on the other hand, is called ‘oversold’, and hints at a possible bounce. This simple interpretation has a mixed historical record for timing reversals (overbought readings can get even more overbought, and vice versa), though extended readings do measurably tend to impact volatility.

Another way to use RSI – and the subject of this particular post – is to identify when trends may be slowing through the observation of momentum divergences. A momentum divergence occurs when prices set a new, incremental high, but RSI fails to do so. Divergences often require corrective action, through sideways or falling prices, but they aren’t perfect timing mechanisms – the existing trend can continue for an extended period even after the divergence first appears. For a valid signal, it’s important for prices to confirm weakening momentum with an initial move lower.

Potential divergences (those currently lacking price confirmation) are piling up at both the index level and in individual stocks. Here are a handful to keep an eye on in the coming weeks.

The S&P 500 has made 3 successive new highs since getting overbought in January, but momentum has declined on each successive rally.

The Russell 2000 Index was posting strong RSI levels in February, but failed to get back above 70 on the most recent advance.

At the sector level, Financials and Communication Services have seen momentum falter over the last month, while prices have continued higher.

For each of these groups, a break below the March lows would act as confirmation of the signal, and could spell trouble for stocks in the coming quarters.

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.

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Let’s get one thing straight: Interest rates are still incredibly low. At a mere 1.6%, the rate of interest on a U.S. Government 10-year bond is still a fraction of the 15% yield offered in the early 1980s. Nonetheless, that 1.6% is already 100 basis points higher than the low set on August 4th last year. And while such an increase is hardly unprecedented, the pace, coupled with the backdrop of a Federal Reserve that has offered no indication of raising its target for the benchmark overnight rate, is far from ordinary. As a result, term spreads have widened significantly since last summer.

The difference between yields on 10-year and 2-year Treasuries, charted below, is now at the widest level since 2015 and shows little sign of slowing its ascent. Though in the middle of its long-term range, one more year like the last and spreads would match the highest levels of the last half-century.

The yield curve has steepened more dramatically in the last 6 months, at a rate not seen since the financial crisis more than a decade ago. And a rapidly steepening curve has tended to precede below average equity returns.

Using z-scores to normalize the interest rate data, I compared 6-month changes in the ’10s minus 2s’ yield spread, to ensuing changes in the S&P 500. The results were significant:

A steepening curve (higher z-score) tends to precede below average returns, while a flattening curve (lower z-score) is generally followed by above average returns. The relationship is most clear at extremes – when yield spreads rise too far, too fast, future returns are often negative.

The current z-score is above 2, sending a cautionary message to stock market bulls. No indicator is perfect, though, and we need to be aware of outliers. The chart below overlays the S&P 500 Index with periods where the z-score exceeds 1.5.

The spread indicator was most effective during the dotcom and housing selloffs, and again proved reliable in 2011. Signaling caution before each of those declines gives this indicator its merit. The record was more mixed in the early 90s, with a warning arriving too late to protect from the period’s largest selloff, but then providing adequate caution against below-average returns in the following years. On the other hand, poor results were achieved if investors blindly followed the indicator in 1985, 2009, or 2013, when equities turned in strong gains. Indeed, this indicator is not infallible.

With equity indexes at all-time highs, two of the most recent occurrences stand in stark contrast: 2008 and 2013. What will it be this time? Are stocks headed for pain, or is this a false alarm we can safely ignore?

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.

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On December 21, 2017, the Tax Cuts and Jobs Act was signed into law. Though the 185-page bill contained a multitude of changes to federal collection laws, the most important for publicly traded companies was a reduction in the corporate tax rate from 35% to 21%. The cut was a direct benefit to the bottom line of most businesses and helped drive earnings to a year of outsized growth in 2018. For the S&P 500, EPS jumped 21% that year, roughly 3x the long-term average.

The TCJA was a popular debate topic during the ensuing 2018 and 2020 election cycles, and the current administration ran on a platform that included moderating the corporate tax cut. Their initial target: 28%. With majority control in both houses of Congress, the effort to enact the increase is likely to succeed, though the timeline for passage is unclear. The impact of the 2017 act may offer clues as to how a new tax bill would affect stocks.

In the years before the TCJA, the effective tax rate for the S&P 500 index was roughly 27%, eight points below the headline rate thanks to a complex array of deductions and loopholes, but still among the highest in the advanced world. The tax cut aggressively lowered the headline rate by 14%, but also eliminated some loopholes – from 2018 to 2020, the aggregate effective rate was only 9% lower than before. As is usually the case, some sectors benefited more than others.

The Utilities sector, which formerly paid the highest rate, saw by far the largest payment reduction. Meanwhile, sectors like Information Technology, Health Care, and Materials, which paid among the lowest rates, saw smaller reductions. Notably, Tech managed to maintain its leading tax rate position (excluding Real Estate, whose constituents are taxed in a different manner), while Energy has paid the highest effective rate in recent years.

In large part, stock prices responded to the cut in logical fashion. The first text of the TCJA bill was released by House of Representatives members on November 2, 2017. It took only a month and half for the text to be finalized by both houses of Congress and signed by the President – a breakneck pace in the federal legislature. Because the Act was so significant and the timeline so short, much of the change in stock prices over that time can be attributed to the bill. The table below is sorted by sector performance between the two key dates. The third column notes the relative reduction in effective rate we observed in the table above.

The Utilities sector stands out. Though it received the largest tax rate reduction, it turned in the worst performance. Investing can be hard, sometimes. Putting aside that clear outlier, the correlation between performance and rate reduction is pretty remarkable. The sectors benefitting the most from the TCJA meaningfully outperformed those benefitting the least. Sometimes, investing can be easy.

Should a corporate tax hike be implemented, it seems reasonable to assume that sectors and companies which saw the most benefit in 2017 would face the most harm now. Of course, it’s never quite that simple. We are talking about politics in modern America, after all. A potential tax bill will undoubtedly be riddled with provisions that benefit some groups and hinder others. We’ll know more of those details soon enough. In any case, it’s important to keep the hike in context: even if the target of 28% is achieved, the effective rate paid by businesses will still be lower than it was prior to 2017.

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.

Amid an astonishing rally from the coronavirus induced lows last March, the Real Estate sector has largely been left behind. The group is still 8% below it’s pre-pandemic highs, and on a relative basis has fallen to its lowest level vs. the index since 2009.

It’s hard to think of a worse time for U.S. Real Estate than the years surrounding the Great Financial Crisis. Needless to say, it’s a time and price level that hold meaning. If there was ever a time for this sector to outperform on a relative basis, it would make a lot sense for that outperformance time start here, at the 2009 lows. Granted, this is a sector mired in a long-term downtrend. We need to be careful when looking for reversals since, by definition, trends are more likely to continue in their existing direction than reverse. Still, this is likely a level that prices respect. Real Estate could easily keep pace with the broader stock market index, or even outperform it, for a year or more without changing the longer-term downtrend. They’ve done so more than once over the last 15 years.

At the same time, the sector on an absolute basis just managed to reach it’s highest level since the March lows. Resistance near $240 had been trouble since it was first reached in June 2020, and prices consolidated below it for 6 months. But the action in early February was enough to finally break through the overhead supply. A few more days of strength and momentum could reach bullish overbought territory.

A handful of breakouts in Real Estate sector sub-industries have fueled the recent strength. The Real Estate Services sub-industry just hit new all-time highs. Prices in 2020 were rejected at $500, the 261.8% extension from the 2008-2009 decline. With that level now acting as support, the next key overhead extension lies near $700.

Residential REITs rallied above a key level, too. The area near $190 first became resistance in 2017, and gave the group trouble again in 2020. Following the breakout, with momentum in a bullish range, the 2019 highs are in focus.

Retail REITs have been among the weakest sub-industries in recent years, having trended lower since 2016, but this month they’re among the leaders. Momentum is in a bullish range, and support is clearly defined. That should set them up to challenge the 2008 highs near $110.

The Industrial REITs, on the other hand, have been among the strongest sub-industries. They’re in a multi-year uptrend, and completely recovered from the pandemic before the end of June. Prices have subsequently been stuck below $95, which also happens to be the 2008 all-time high. If the sector continues higher, Industrial REITs will almost certainly be breaking out.

We can likely say the same about Specialized REITs. This group led its peers for most of the last decade and quickly recovered from last spring’s selloff, but they’ve failed to make progress over the last few months. Clearing resistance at $300 will be key to reclaiming a leadership role.

The Office REITs have not been leaders in any environment over the past 5 years. They’re stuck below $155, a level that acted as support from 2015-2019, and then as resistance over the last 12 months. Laggards tend to lag. It shouldn’t surprise us to see the weakest groups struggle to move higher.

But Office REITs may provide a clue as to whether the Real Estate sector can rally from its 2009 relative lows. If Office REITs fail to absorb overhead supply, then the sector as a whole will struggle to outperform. Alternatively, Office REITs above $155 would be a sign of strength. When even the weakest groups can rally higher, it’s hard to be negative.

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.

The GameStop saga dominated the financial news flow this week. It’s a thrilling story, likened to David vs. Goliath, in which a group of online amateurs teamed up in an effort to defeat the ‘villains’ of Wall Street. If you’re unfamiliar with the plot, there is no shortage of commentary (and opinions) detailing the various ‘squeezes’ and manipulation attempts that have driven the price of GameStop’s stock over the last several weeks. I won’t waste my evening writing about it too. Let me just say this: The drama feels unprecedented. In reality, though, this is a story markets have told time and again throughout history. Overconfidence, excessive leverage, poor risk management, and liquidity shortages tend to result in catastrophic problems for some, and opportunities for others. The market has a way of catching people off guard. If you think you know who all the winners and losers of this tale’s most recent iteration will ultimately be, you might want to think again. The story of GameStop is far from over.

But for most investors, GameStop is just that: a story. While its implications are certainly broader than the outcome of a single stock price, we have to be careful not to miss the forest for the trees. While a few heavily shorted stocks rallied, the S&P 500 Index tumbled from its Monday highs. The resulting weekly candle was, in the field of technical analysis, a classic reversal pattern.

A ‘bearish engulfing pattern’ consists of one up candle followed by a down candle. On the second candle, prices open above the prior close and close below the prior open, so that the body of the second candle ‘engulfs’ the body of the first. In the case of the S&P 500, last week’s candle engulfed the prior 3, increasing its potential significance.

The indicator is considered valid if it follows a recent uptrend in stocks, and, in theory, is likely to mark a turning point. Given last week’s candle immediately followed an all-time high, how confident should we be that a change in trend has actually occurred? I took a look at history for some clues.

As with any such backtest, assumptions are important. For this one, I analyzed weekly data for four major US stock indexes: the S&P 500, Dow Jones Industrial Average, Nasdaq 100, and Russell 2000. After finding each occurrence of a down candle that engulfed a prior up candle, I narrowed the list to those occurring within an uptrend – prices had to have risen over the previous 5 weeks.

The result was 166 total bearish engulfing candles in just over 7,000 weeks of data, or roughly 1 occurrence per year. Here’s how indexes performed afterward:

At first glance, the data was far from groundbreaking. Sure, stocks have underperformed their averages in the 2 and 4 week periods following a bearish engulfing candle, but the margin is thin – only 14 basis points in the initial 2 weeks. And by the end of the eighth week, stocks were actually doing better.

A closer look yielded more interesting results. The Nasdaq 100 severely skews the data. In fact, a bearish engulfing candle has actually been quite bullish for the tech heavy index. Check it out:

The Nasdaq candle didn’t quite qualify this week, so this is some data to keep in mind for the future. I’ll be interested to see whether it can continue to buck conventional wisdom.

Alternatively, the other 3 indexes adhere more closely to the textbooks. With the Nasdaq excluded, equities on average demonstrably struggle after the reversal pattern:

For 4 weeks after the negative candle, stocks tended to still be down nearly 20 basis points. That’s nearly 1% worse than would be expected otherwise, and certainly material enough to bear watching.

Feel free to keep up with the GameStop story. It’s sure to be one we’ll remember as the years pass. But don’t let it distract you from the broader moves. After the S&P 500’s reversal in the final week of January, history warns us to approach February with some caution.

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.

The S&P 500 Energy sector is up 11% this month, double the return of the next best sector. Those of you who’ve followed Means to a Trend over the last year and a half are familiar with Energy’s track record: it’s been a serial laggard since 2008. Here’s how the sector has performed vs. the broader index over the last few decades.

In January 2020, Energy’s value relative to the S&P 500 dropped below the 1999 lows and accelerated. When the price of crude oil fell to negative $40 in April 2020, it seemed things couldn’t possibly get any worse. But they did. As the Information Technology sector led stock indexes on a breathtaking rally from recessionary lows in March, to new all-time highs in September, Energy was busy falling to multi-month lows.

Since the end of October, though, Energy is on track to turn in its best relative 3-month performance in at least 30 years.

At the same time, the sector (on an absolute basis) has managed to recapture its 2008-2009 low, a key level that it lost early last year and failed to hold during the initial bounce.

Similarly, battles rage with the 2008-2009 lows in 3 of Energy’s 5 sub industries. Here are the Integrated, Equipment & Services, and Exploration & Production groups approaching the key resistance level.

Meanwhile, the next challenge for the Refining & Marketing sub industry is the 2007 highs. Notably, the early 2020 lows occurred right near the 38.2% retracement from entire 2007-2008 decline.

Fibonacci levels have been a helpful roadmap for the Storage & Transportation sub industry as well. The initial rally from last year’s lows failed near the 61.8% retracement from the 2008-2009 decline, but then held the 38.2% on a backtest. The group has recovered, and the next major resistance is a level that was constant trouble from 2016-2019.

Despite all the progress, prices for the sector and each of its industry components are stuck below long-term moving averages. It’s hard to have confidence they’ve escaped their multi-year downtrends. Still, every long-term reversal starts with a short-term rally. With another 3 months like the last, Energy could find itself back in the limelight once more.

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.

Bonds are a staple of investment portfolios in the modern era. They don’t just help to offset the volatility associated with stocks. Since January 1926, an investment in long-term (20-year), risk-free U.S. Treasury bonds would have annualized at 5.70%. Nearly 6% per year from an investment guaranteed by the United States Government sounds like a pretty good deal, especially in today’s world of near-zero interest rates. The performance certainly deserves some credit for popularizing the “60/40” portfolio. But alas, things are not always what they seem.

Over the last 100 years, long-term bond investing in the U.S. resulted in quite different outcomes for investors, depending on when they started. Many investors today have never experienced a true bear market in bonds. In the early 1980s, interest rates peaked near 15%, and have fallen steadily since. Not only did bond investors of the 80s and 90s get to purchase abnormally high yielding bonds, but they also benefited from capital appreciation related to falling rates. Additionally, they invested in a world where inflation was falling.

Inflation is the arch-enemy of bond investors. Since 1926, inflation has chipped away half of the 5.70% annual return achieved by U.S. bonds, resulting in a more sobering 2.76% return per year in real terms. Unsurprisingly, inflation took the largest toll during the 1970s and early 1980s, but when rates are low, even subdued inflation has an impact.

The impact is clear in the decades prior to the 1980s. In fact, buying long-term bonds was a remarkably terrible decision from the 1930s throughout the 1960s. The chart below depicts the real annualized return for someone that invested in bonds for a 20 year period. Note that while the average annual return (inflation adjusted) over the entire period was 2.76%, hardly anyone with a 20 year time horizon actually experienced that 2.76%.

As one of the aforementioned investors that’s never seen a bear market in bonds, it’s hard to fathom losing nearly 4% per year for 20 years. Moreover, it highlights just how remarkable the interest rate environment of my lifetime has been. Returns are positive for investors of the 1920s, but that’s largely a result of deflation in the 1930s. Putting that aside, virtually ALL of the cumulative real returns for bonds over the past 100 years have been achieved in the last 40 alone.

To further illustrate the true impact of bond returns, imagine you made a $1 per month contribution for 20 years. By the end, you’ll have contributed $240 to your ‘bond retirement fund.’ Investors that started in 1961 had less than $150 in equivalent dollars after 20 years of saving and contributing. Alternatively, an investor in 1977 would have ended with more than $600.

A few months ago, I discussed how ‘average returns’ in the stock market can be misleading. The same holds true for bonds. In investing, there are no guarantees of success or failure. Whether you’re a long-term investor, trend following speculator, or momentum-chasing day trader, we’re all playing a game of market timing.

If you missed my reviews of U.S. stock market returns, be sure to check them out here and here.

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.

A year ago, I laid out the consensus expectations for S&P 500 earnings in the years ahead and used them as a framework to develop reasonable expectations for equity performance in 2020. I think it’s safe to say the year turned out a little different than we all expected. At the time, the average analyst believed the index’s forward earnings per share would be $193 at year-end. They were less than $170 in late December. Similarly, the valuation multiplier was just above 18x last January, and I believed anything between 14x and 22x (a range wide enough to float a barge through) was reasonable to expect by year end. I should have opted for something larger than a barge. On December 31st, the S&P 500 closed at 3756.07, or 22.6x forward earnings.

In the words of the great Yogi Berra, “It’s tough to make predictions, especially about the future.” Two thousand and twenty reminds us all to take forward-looking statements with a grain of salt.

That said, I think it’s important to have a roadmap for what’s ahead. In any year, the ride is bound to get bumpy – but the map can tell you whether you’re truly off-course or just taking a detour. So let’s look at 2021.

If you’re like me, you’re still getting used to the idea of 2020 being in the past. But right now, 12-month forward EPS includes estimates for 2022 data. That means any discussion of year-end S&P 500 levels derived from a forward multiple is based on earnings reports that we won’t get for more than 2 years. Still, we have to start somewhere.

According to Bloomberg, the consensus estimate for 2022 EPS is currently $192, but consensus estimates are habitually too optimistic, as noted by macroeconomic strategist Ed Yardeni. He publishes this chart to illustrate:

The blue squiggles represent the consensus analysts’ earnings per share estimates for any given calendar year. With a few exceptions, initial projections are simply too high, and analysts are forced to revise their estimates lower as time passes. On average, that revision is between 5% and 10%. If estimates were to follow a normal trend, forward 12-month earnings at the end of this year would be about $177 per share.

Here’s what that all means for prices in 2021. If analysts have it right and we’re able to maintain the same multiple, stocks would return 16% this year. Alternatively, if earnings trends follow a traditional trajectory and multiples remain constant, stocks would have a slightly below-average year.

If valuations rose to their 1999-2000 highs, stocks would have a fantastic year in either earnings scenario. On the other hand, there would be disappointment on Wall Street if multiples fell back to 2019 levels.

Of course, that’s all based on current earnings projections, and 2020 reminded us how erratic those can be. The pace of vaccinations, extent of further lockdowns, appetite for spending, and magnitude of stimulus packages will all play key roles in the 2021 earnings recovery. Stay tuned.

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.