$SPX - Grindstone Intelligence

August 26, 2019

Material Deficiency?

On Friday, the S&P 500 faced an above-average decline of more than 2.5%. Despite the drop, the index has yet to break out of its August trading range. The same can be said for most of the sectors – the swing lows from earlier this month were held. The exception, however, was Materials. With Friday’s poor performance, nearly one-third of its members were setting new 52-week lows. Here’s a closer look at the developments:

The worst performer of the group has been Commodity Chemicals. Prices are below a downward sloping 200-day moving average, and are now at the lowest levels since 2013, the year this index began. A swing high from early that year is the nearest support level. Momentum is clearly in a bearish range but has not gotten oversold on this most recent breakdown. If the sub-industry can get back above $123, the false break-down combined with a positive momentum divergence could revert prices back to the 200-day mean.

Diversified Chemicals have been weak as well. This month, they tried and failed to get above the 161.8% extension from the 2007 – 2009 decline. Bulls will want to see prices regain $333, but if the May lows fail to hold, the 2007 high of $226 comes into focus.

The Metals & Mining industry just set new lows for August, but with prices near a flat 200-day moving average, the group lacks a trend. A break below $90 or above $110 would be significant, but until then it’s a waiting game. Notably, momentum hasn’t gotten oversold on this most recent pullback.

Fertilizers & Agriculture Chemicals is a similar setup – no trend. The group hasn’t gone anywhere for a decade, but if they can get above $1531 again, the 2007 highs at $1830 are in play. Meaningful support lies near $1300.

Containers & Packaging is trying to reestablish an uptrend. Prices tried to break down in the fourth quarter of last year, but managed to recapture $233. The chart is ok as long as they hold those 2015 highs, but the $278 resistance level is key for longer-term bulls.

Specialty Chemicals is having trouble getting through the $1278 level. The index is still in an uptrend, but the trend and momentum are weakening. After nearly two years of trying, prices could be ready to break out with some conviction toward $1500. A failure to do so and subsequent break of the uptrend line would signal either more time is needed or the uptrend is over.

Speaking of levels that are hard to get through, Construction Materials has been fighting with $255 for more than 10 years. It may have finally broken out. It’s spent most of August consolidating above, with $317 as the next extension. Momentum has weakened into the new highs though, so the index isn’t out of the woods. Bulls don’t want to see prices back inside the multi-year trading range.

The best performer of late has been within Industrial Gases. The group had been setting new highs for most of 2019, but, after a negative momentum divergence, dropped sharply in August. The trend is still very much intact, with prices well above their 200-day moving average, but the index is squarely between support near $1280 and the next extension at $1633.

Looking ahead, for the Materials Index to halt its decline, it needs its winners to keep winning and its losers to stop losing. If this highly cyclical group can do that and get upside resolutions in a few other areas, the sector, and most likely stocks as a whole, will be doing just fine.

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts 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.

July 29, 2019

How Much Does Fed Day Matter?

Eight times a year, thousands of economists, analysts, and money managers tune in as the Federal Open Market Committee releases a statement about their policy decision. We’ve all heard the age old adage ‘Don’t fight the Fed,’ but does Fed day really matter? I decided to take a look.

For this study, I define ‘matter’ as resulting in a peak or trough in prices over a predetermined time period. Put simply, I look for a well-defined change in the trend.

On any given day, the odds that the price of the S&P 500 Index is higher than both the preceding 5 days and the 5 days to follow (a peak) is 5.9%. The odds that a day’s closing price will be the low of the total 11-day period (a trough) is 6.0%. Thus, the odds that any day of trading marks a definitive peak or trough is 11.9% (6.0% + 5.9%). We can use the same logic, with different time intervals, to identify more significant turning points. The table below summarizes my findings for the S&P 500 and the U.S. 10-Year Treasury Yield.

So what happens when we overlay FOMC decision dates? I pulled every meeting and decision date since 1993 and compared it to our baseline data. Let’s look at equities first.

Fed days are about 1.5% more likely to change the trend over an 11-day period, 2.5% more likely over a 31-day period, and have virtually no bearing over a 3 month period. On a weekly basis, decision week is 3.3% more likely to occur while equities are setting 5-week highs, but have less bearing over longer time frames.

The impact on Treasuries is somewhat larger, especially on a weekly basis.

Notably, Fed decisions are more likely to result in yields topping over 11-day, 5-week, and 13-week periods.

The evidence clearly indicates that FOMC meetings do measurably increase the odds of market turning points, but what does a 4.8% (the maximum for any time period in this study) increase in the odds actually mean? It means for that time period over the last 25 years, 11 more meetings resulted in trend changes than what would be implied by the baseline – only one meeting every 2.27 years. Even when we choose the most favorable time period, there’s still a 95% chance that a Fed meeting won’t change the trend.

As someone who reads each FOMC press release and watches every press conference, that hurts. No one wants to feel like they’ve wasted their time. But I’m not yet so cynical to believe the Fed doesn’t matter at all. Given how actively Fed members work to manage expectations, perhaps this is really a tribute to their success in not surprising market participants (that hurts, too. The last thing I want is more Fed talk).

As we head towards another meeting this week, I know I’ll still read the release and watch Mr. Powell answer questions – the backdrop of monetary policy is a vital input to any top-down macro approach. That said, these findings definitely reduce the weight I’ll place on market activity around decisions. I’ll spend more time trying to identify the current trend and less trying to find something that will change it.

What do you think?

July 15, 2019

An Update On Market Breadth

The concept of breadth is pretty simple: the more stocks that participate in a trend, the stronger that trend is. All 3 major stock indexes in the United States set new weekly highs, but how strong is the trend?

The cumulative advance-decline line might be the most well-known breadth indicator. The calculation is easily understood (the difference between rising issues and falling issues at the close is added to the previous day’s value), and it has reliably diverged before many of the largest bear markets. It’s a good place to start for a market breadth review. Right now, advance-decline is signaling the all clear – as the indexes have set new highs, so has the cumulative A/D line.

The percent of stocks above their 200-day moving average is healthy, too. Moving averages are, by definition, lagging indicators, and recent studies have cast doubt around their reliability as trading signals, but I find them useful as a litmus test. When an issue trades above a moving average, it’s hard to argue that it’s in a downtrend (and vice versa). Right now, 74% of stocks are above their long-term moving average. That’s just as good as anything we’ve seen since the January 2018 peak.

The number of stocks setting new highs and new lows is somewhat weaker. As the market has rallied over the past month, the New Highs index has set a string of lower highs. This divergence is a cause for concern, but divergences are not meaningful unless they’re confirmed by a price reversal. A larger red flag will be raised if we start to see an expansion in new lows accompany the decline in new highs.

The measures above are some of the most common ways to look at breadth, but it’s also important to account for the current environment. Stocks have struggled to gain traction since the run-up that ended in January 2018. They tried to break higher last October, but failed in dramatic fashion and fell 20% by Christmas Eve. When the S&P 500 rallied and first exceeded its 2018 highs in April of this year, only 182 of the 505 members had done the same – a 7% correction followed. As of this writing, 221 members have exceeded their 2018 highs at some point this year – a significant improvement, but still less than half. Those readings are somewhat comparable to the latter half of 2016, when the first breakout attempt (September 2016) had only 39% participation and resulted in failure, but the successful second attempt (November 2016) had 50% participation.

The picture deteriorates somewhat when you look at current prices. Only 177 constituents (35%) are currently trading above the 2018 resistance. Additionally, Utilities and Real Estate are the only positive sectors, with all but 16 of their combined 60 members trading above 2018 peaks. The majority of stocks in each of the other 8 sectors are beneath those key levels.

Put simply, broad swaths of the market are still stuck below resistance – the median stock in the S&P 500 is 7.5% below its 2018 high. Participation could clearly be better, but it’s less clear whether it’s weak enough to necessitate another correction. Markets are regularly led by a few strong names, and they can drive prices higher for longer than anyone expects. One thing I’m sure of: a broadening in participation would be extremely healthy for stocks as we move forward, but the cyclical sectors have some work to do.

July 8, 2019

Independence Day Edition: Proud to be an American

There’s no place like home.

Few biases are more difficult to overcome than home bias – the tendency of people to allocate most of their investment portfolio domestically. Any investing textbook can tell you that biases tend to be harmful to your portfolio, but Americans who’ve succumbed to home bias can be thankful.

U.S. equities have convincingly outperformed their international counterparts since the end of 2008.

Bond yields, too, are more attractive domestically. The risk-free 10-year rate in the U.S. has averaged 2.5% over the last 10 years, while similar credits like Germany and Japan, aided by central bank policies, have paid investors substantially less.

From a broader economic standpoint, the U.S. is again an out-performer. A few weeks ago, I wrote a piece titled Bad vs. Less Good. The chart below could have the same title. The JP Morgan Global Manufacturing PMI has dropped below 50, signaling a contraction, yet the reading for the United States is still in expansion territory.

Looking Ahead

The S&P 500, Dow Jones Industrial Average, and Nasdaq all set new highs this week, while most of Europe, Asia, and Latin America are still below previous peaks. On a relative basis (below), the 10.3 ratio level was established as important resistance throughout 2018. After surpassing that level earlier this year, the ratio has consolidated and remained above the support. The underlying trend is still up, but a break back below 10.3 would be a trouble sign for U.S. equities on a relative basis.

Keep an eye on the data and watch the levels, but as you wrap up your Independence Day celebrations, be a little thankful if you’ve been invested in the United States of America.

June 10, 2019

Bad vs. Less Good: The U.S. Economy

On Friday, the S&P 500 closed at 2873.34. For those of you keeping track at home, that’s a whopping 0.02% return since the January 26, 2018 peak. (If you prefer the Total Return measure, that’s enough annualized return to keep even with the current inflation rate.) When it comes down to it, stocks have done next to nothing for almost 18 months. It might seem that given a relatively unchanged equity market, the economic environment must also be relatively unchanged. That isn’t the case.

The year 2017 was highlighted by ‘synchronized global growth’ – economic activity increased around the world, accompanied by stock prices. The good times continued throughout the first month of 2018, and, even after a global equity selloff in February, data for most of last year indicated that underlying fundamental growth would continue. New highs for U.S. stocks in September seemed to confirm that everything was fine, but then a steep 4^th quarter selloff and the ensuing rally brought us right back where we started.

Following the trend in year-over-year equity returns, the economic data has more recently softened. But is the data actually bad, or just less good? Let’s take a look.

You can’t get much broader than GDP. After breaching 4% in the middle of 2018, growth in the United States declined to 3.2% in Q1 2019 just above the 2.3% average since 2010. The St. Louis Fed’s GDPNow estimate points to continued slowing in Q2 2019 (1.39%), but no contraction.(Click charts to enlarge)

The unemployment rate is at 3.9%, the lowest in nearly 50 years and much better than the 70-year average of 5.8%. But the rate of jobs growth is slowing. Friday’s BLS report showed a subpar addition of only 75,000 jobs. A similarly weak print in January was written off as a ‘blip’, but two blips start to resemble a change in the trend. Moreover, a separate measure of payrolls from ADP showed a decline of 35,000 jobs in construction, accompanied by losses in manufacturing and natural resources. Those aren’t things we want to see in May, when outdoor activity should be picking up. Weather might have been the cause, but weather is like alcohol – it tends to get blamed for a lot of things it didn’t do.

Survey data doesn’t inspire much confidence either. While the services side has held up better, the Markit Manufacturing PMI has declined from its 2018 peak of 56.5 to 50.5 – still above the 50.0 flatline, but the lowest reading since 2009. The New Orders component of the survey, generally considered a leading indicator, is in contraction.

Profit margins for companies in the S&P 500 peaked last year (in case you haven’t noticed, this is a recurring theme). Rising labor costs and tariff impacts, among other things, have reduced margins from 12% to 10.9%. On the bright side, that’s the same nominal benefit received from the 2017 tax cuts, so the net change over the last 2 years is essentially zero.

We round it out with earnings. S&P 500 earnings per share are estimated to set a new all time high in 2019, which has helped reduce the forward P/E multiple from 18.5x to 16.2x. Year-over-year growth in earnings is less exciting. The first quarter of 2019 actually saw earnings decline according to FactSet’s blended calculation, and almost all of the anticipated gain for the calendar year is expected to come in the final months. Additionally, consensus EPS estimates typically trend down over time, so full-year growth projections should always be treated with skepticism.

What’s Next?

The weaker data has caused a major shift in expectations for Federal Reserve action. After 3 hikes in 2018, Federal Funds futures markets in October had priced in, with over 90% certainty, at least one more hike by December 2019. The forecasters have since reversed course – not only are they pricing a 0% chance of a hike, the odds now suggest a 99% chance of an interest rate cut.

The aforementioned easing in monetary policy has been categorized as an ‘insurance cut’, intended to offset tariff impacts and stimulate inflation rather than counter an economy already in decline. As reinforcement, FOMC members have been careful to say that no recession is imminent, but economists don’t have the best track record when it comes to predicting recessions (more on that later).

To sum it up, most of the data is still just less good, as opposed to being outright bad, and the Fed seems to have our backs if things do deteriorate further. A weaker economic outlook suggests a cautious approach to equities, but remember, equities discount the future. A break to new highs for the S&P 500 may foreshadow an improvement in data, just like it preceded the slowdown in 2018 (alternatively, a break to new lows might signal a coming recession). But as of today, neither is the case – equities are still rangebound and economic data is mixed. We aren’t out of the woods yet.

May 28, 2019

Watching Headlines? Here’s Why It Could Be Bad for Your Health

I felt dirty after writing that title. I actually debated between that one and ‘Warren Buffett Doesn’t Pay Attention to Headlines. Here’s Why You Shouldn’t Either” but I couldn’t independently confirm (with zero effort) whether he does or not. The point is, clickbait is the worst. At the same time, you’re reading this post, so it clearly works – that is, if your ‘work’ is to get get as many clicks as possible.

I get CNBC notifications on my phone. The headlines they push summarize what’s happening in markets, and they can be a useful tool for informing advisor/client communications. But remember that news agencies’ jobs are to get views. As investors we’re tasked with keeping news in perspective and not letting emotions control our actions.

Sometimes that’s easier said than done. Here’s a sample of some CNBC push notifications I’ve gotten over the past year.

It’s a lot to take in. The trade war is clearly a mess. 700 points?! First time since 2011? 2004? Those are big moves and historic data points. Can you really blame a news agency for sending me such important information?

Here’s the problem: I lied. Those notifications weren’t from the last year. That’s just the past two weeks. And I didn’t even come close to showing them all. Some pushes conflicted with reports from mere hours earlier, and almost all of them cited ‘huge’ market moves. Granted, there have been some larger than average intraday moves, but sending a notification for every 100 Dow points? That’s not helpful. (Side note: You can bet 100 Dow points catches a lot more eyes than 11 S&P 500 points, even though they’re .)

If you only look at headlines, it sounds like all that breaking news was driving major swings in stocks, but if your time horizon is anything longer than a few days, those swings haven’t mattered and those headlines haven’t added value. The chart below shows the S&P 500 over the last year, and that little red square is the two-week period in question. Despite all that noise, equities haven’t really gone anywhere.

Yes, the trade talks are important. Economic data is important. Fed policy is important. But a banner on your phone and a 20-minute, algo-driven spike doesn’t mean the environment has changed. Remember to keep it things in perspective.

Real news matters. Headlines don’t.

May 20, 2019

It’s Getting Harder to Be a Day Trader

Full Disclosure: I’ve never actually been a day trader. It might be the golden age of day trading for all I know, but I do know a major change has taken place since 2016. No, I’m not talking about a certain Twitter addict. I’m talking about futures markets.

The CME launched the E-mini S&P 500 futures contract in 1997, and they can be traded nearly around the clock. If Russia declared war on the United States at 2:30 tomorrow morning, you could instantly sell some futures contracts rather than waiting for the cash market open (that’s not a recommendation for what you should do if Russia declares war tonight. In fact, you should probably find shelter). Transactions in the overnight futures market have an impact on where stocks open for trading every morning, and gaps (differences between opening and closing prices) are accounting for more and more equity market gains.

To gauge the impact of after-hours trading on market returns, I created two performance indexes: Daylight and Overnight. The first ‘buys’ the S&P 500 cash open at 9:30 ET and ‘sells’ the closing print at 4:30 ET. The second ‘buys’ the S&P 500 cash close and ‘sells’ the open on the following morning.

There was a time when the overnight session barely mattered. (Click charts to view them full screen)

The Daylight index (Red), excluding its superior performance during the financial crisis, tracked the S&P 500 (Black) with near perfection from 1998 to 2013. Unsurprisingly, the two had a near perfect positive correlation. Even through the first half of 2016, 3 years after the Overnight index (Blue) began to show consistent signs of life, the correlation held steady.

But the winds changed in the middle of 2016.

The correlation between the Daylight index and the S&P 500, while still high, has notably deteriorated since then. More importantly, the Overnight index has outperformed the Daylight index from that point in August 2016 to now. In fact, it’s accounted for about 70% of the S&P 500 gains over that time. If you’ve been day trading, maybe it’s time you took up night trading instead.

Another perplexing trend is a divergence in performance over the past few weeks.

Since early May, the S&P 500 has fallen more than 4% in the overnight trading sessions but has been up over 2% between the opening and closing bells. I can’t find a comparable period of such sustained and conflicting movement in after-hours trading. Even if I could, with only 3 years of relevant data, I wouldn’t have much confidence in assessing what it’s meant in the past. I certainly don’t know what it means for the future.

What I do know is this:

Gone are the days when markets truly closed. More than ever, being a money manager is a 24-hour gig.

Questions or Comments? Let me know