PRO-EYES


Last Update: July 19, 2021

Jump to section: Valuation | Business Cycle Factor | Tactical Factor

The overall PRO-II composite was up slightly last week and remains in the cautious range. Liquidity measures are supporting the higher valuations, but risks are growing that liquidity measures may tighten going forward. We are seeing offsetting movements in the tactical indicators, but negative seasonals are coming with ample catalysts and building divergences. High caution is warranted and cheap volatility can be used to hedge portfolio risks.

VALUATION

Risk Level: 93%

Valuation remains extreme. Bond yields may have hit a low point last week with a negligible impact on equity markets as yields remain within recent ranges. New all-time highs on the S&P 500 are keeping pace on a forward PE, PS basis. We have never seen the Price-to-Sales ratio for the S&P 500 at these levels including the 2000 valuation extremes. Focus will turn to earnings for the next 6 weeks, but we expect stress from debt supply to matter in August and September. Catalysts for equity risk premium to continue to contract are low in the coming months.

Enterprise Value to EBITDA

A reading near or at 100% means the EV-to-EBITDA is the most expensive it has ever been. The average returns over the coming years will likely be well below average. While the market is expensive historically, this metric suggests returns will be well below average and should not be used as a timing indicator, but adds to the cautionary valuation environment. Enterprise value, is the sum of debt and equity capital a company uses less cash like holdings on the balance sheet compared to earnings before interest, taxes, depreciation and amortization. In other words, how much capital is used to generate free cash flow.

Price-to-Sales

A reading near or at 100% historically means the average returns over the coming years will likely be well below average. While the market is expensive historically, this metric suggests returns will be well below average and should not be used as a timing indicator, but adds to the cautionary environment. The revenue a company generates is less subject to manipulation (financialization) like earnings per share can be and can be a better valuation metric than comparisons to earnings. Many industries have higher margins, so price-to-sales is not a perfect guide.

Forward P/E

A reading above 90% historically means the average returns over the coming years will likely be well below average. While the market is expensive historically, this metric suggests returns will be well below average and should not be used as a timing indicator, but adds to the cautionary environment. Earnings expectations are a key factor for market growth. Analysts are often too optimistic on forward expectations. Forward P/Es historically are 2 multiple points below trailing average. The historic average P/E for US large caps is about 16.5x earnings.

Equity Risk Premium

A reading around 80% historically means that ERP is very high, but is not extreme. The combination of stimulative interest rates and stock market multiples offer a cautionary message if either earnings or interest rates do not confirm expectations. Overall, the ERP increased 14.0bps last week. The yield of the 30-year bond declined 7.0bps. The earnings yield of the S&P 500 increased 7.0bps. We have been suprised by the long bond yield response in recent weeks. We see signifcant supply as a problem in Q3+ as the Fed considers reducing asset purchases.

BUSINESS CYCLE FACTOR

Risk Level: 66%

Overall business cycle factors remain extremely stimulative. The change in Fed thinking is just beginning to have an impact on business cycle factors. It’s likely several years away at a minimum before we see credit conditions tight enough to matter. Supply chain pressures are transitory, but it feels much more than that. The ability to mobilize labour in many sectors is boosting costs. Is this a one time boost or a change in expectations. Longer-term deflationary forces remain powerful tamping down core rates. Taper talk in the coming months can be a factor for a market valuation rebalancing.

Slope of Yield Curve

A reading near 60% suggests the yield curve (3-months vs. 10-years) is only slightly flatter than the historical average. A normal sloped yield curve is healthy and is a positive business cycle factor. A curve getting flatter over time suggests financial conditions are tightening. The recent trend has been flatter. Last week, the 3M-10Y curve was 6.9bps flatter

High Yield vs. Investment Grade Credit Spreads

At a reading near 90%, complacency risks are high and investors are not likely being adequatly compensated for credit risk. By itself, it’s not a sell signal outright, but does suggest a high degree of caution in the asset class and for risk assets in general. Credit spread tightness are generally coincident with strong equity markets. A higher high in the stock market that is not confirmed by even tighter credit spreads are a warning signal. The yield-to-worst (maturity) for junk bonds is 3.80%, which is 2.1 standard deviations below average. The recent new highs in the S&P 500 are being accompanied by record low nominal high yields. In fact, the entire high yield basket is trading at lower yields than the current inflation rates. We expect the FOMC will stop support for MBS and credit markets in the coming months. This is an extremely high risk signal for capital markets.

NY Fed Weekly Leading Indicators

Over the past week, the NY Fed weekly leading economic index slowed. The trend over the past month is slowing while momentum is rising. The recent trend suggests evidence of extreme weakness. Historically, the Fed would be looking to take the “punchbowl” away, but they continue to reiterate a willingness to let it run hot. The message from the Fed is now beginning to discuss a tightening of financial conditions. The timing will be debated, but September is lining up for a reduction in mortgage purchases. A reading near 100% is extreme. For more details on the WLI see: https://www.newyorkfed.org/research/policy/weekly-economic-index#/interactive

Real Yields & Inflation Expectations

Over the past week, real 10-Year Treasury yields declined -7.2bps. Nominal yields decreased -6.9bps, while inflation expectations rose 0.00% to 2.12%. Monetary policy is Extremely Easy. We have an extreme unusual circumstance where central banks are encouraging rising inflation pressures and negative real yields. It’s stimulative, but there is an extreme degree of moral hazard and bubble like conditions. We expect deficit funding needs to suck liquidity out of markets beginning in Q3. We also see risk of a fiscal cliff in 2022. Both may impact inflation expectations.

TACTICAL FACTOR

Risk Level: 67%

Overall the tactical factor was higher by about 2% last week. The seasonal factor is now moving to cautious levels while the slight increase in volatility reduced the complacency factor. The most concerning is the lack of market breadth in recent weeks. This combined with negative divergences on the weekly RSI suggested a near-term top is a growing risk. Other sentiment readings are mixed and while current positioning is not extreme, it is elevated.

5-Day Put/Call Ratio
Risk Level: 92%
The Put/Call ratio measures a degree of speculation and hedging in the options markets. A reading above 90% suggests an extreme degree of speculation. The ratio of speculation in call buying relative to put protection remains elevated. The meme stock speculation (AMC, GME) is beginning to weaken, but remains elevated. We can expect options gamma/vega trends to remain an important factor.
Speculative Position S&P 500 Futures
Risk Level: 71%
Positions of speculators in the S&P 500 futures contracts offers a potential future source of supply or demand. Current readings are elevated, it’s not until the position gets to an extreme that it becomes a good contrary indication. As of July 13, S&P 500 E-mini speculators reduced their net long position last week by 5.9 million dollars. This is near the largest net long exposure since extreme readings prior to the US election.
Percentage Deviation from 200-Day Moving Average
Risk Level: 87%
Deviation from trend is a sign of a strong market and a sign of an extreme condition. The current reading is extreme. Corrections in momentum can occur 2 ways. Markets move down to the mean or trend slows and the mean catches the trend. In recent months the trend has moved towards the market. With earnings expectations still moving higher, the S&P 500 has lost momentum, but is still grinding out new highs. Liquidity remains a supportive factor, but that should change in Q3.
AAII Bull vs. Bear Sentiment Spread
Risk Level: 56%
Last week the percentage of bulls decreased -4.0% while the percentage of bears increased 2.3%. We pulled off the extreme readings from the past few weeks, but it’s notable that more money has gone into equities in the past year than in the past 12 years combined. It’s getting FROTHY according to the Fed’s financial stability report. Seems anything but stable… When the percentage of Bulls exceeds the percentage of Bears by a minor amount, market views are mixed and there is enough cash to buy, but still some selling potential.
Seasonal Pattern (All Years) Since 1928
Risk Level: 75%
The 1-Month forward based return is poor. Historically the average return is close to zero. As we get to the end of July, seasonals turn the most negative for the year. This year, there are several catalysts that support a challenging few months ahead.
Presidential Cycle (Current Year) Since 1928
Risk Level: 75%
The 1-Month forward based return is below average based on the current year of the presidential cycle model. We are quickly approaching a period where average seasonal returns turn negative for the next few months at a time where bond supply may suck liquidity out of markets. Not time to chase market strength in the coming weeks of earnings.
Current vs. Average Volatility (VIX)
Risk Level: 40%
Last week, volatility was 14.0% above the previous week. It was +6.2% compared to it’s 50-day average. The 50-day average is -10.7% below it’s long term trend. Volatility jumped last week as we note a weekly reversal pattern on the charts. We have seen similar patterns in recent months with no downside follow-through selling. Still, with other catalysts developing, short-term traders should take notice.
Current vs. Future Volatility (VIX)
Risk Level: 74%
Last week, current volatility was 4.6% above the previous week. Future volatility was 2.9% above the previous week. The ratio of current volatility to future volatility is normal. Expectations of future moves in volatility (i.e. the volatility of volatility) can swing dramatically and shows bearish indications. It is a very good tactical factor for hedging opportunities. When combined with other factors, put protection is attractive with the current shape of the volatility futures curve.
Percentage of S&P 500 Holdings Above 50-Day Average
Risk Level: 26%
The percentage of stocks in the S&P 500 above their own 50-Day averages is 47.9%, which is 8.2% below the previous week. It is 1.7% below the average of the past month. Tactically, not weak enough for a buy signal, but it’s close. It is extremely rare that we see such a low percentage of stocks below their own 50-day average with the markets so close to all-time highs. The leadership is very narrow. The Fed clearly added an end of cycle risk element in June the markets have yet to adjust for. The average stock is looking weaker relative to the market.
Percentage of S&P 500 Holdings Above 200-Day Average
Risk Level: 87%
The percentage of stocks in the S&P 500 above their own 200-Day averages is extreme at 88.0%, which is 4.8% below the previous week. It is 2.8% below the average of the past month. The breadth divergences are building with the new highs in June and slightly weaker breadth readings. With 92% of stocks above their 200-day average, the degree of divergence is not clear. New highs are generally bullish with high participation.
Breadth-McClellan Summation Index
Risk Level: 48%
The breadth of the market is weak. Fewer stocks are participating in the advance. McClellan suggests the duration of breadth thrusts is a key variable in supporting the trend. It’s been strong for months. However, there is a developing divergence with recent market highs not being confirmed by key indexes and breadth readings.
Overbought-Oversold 13-Week Relative Strength Index
Risk Level: 78%
The 13-week RSI is near extreme at 68. Caution is warranted. Overall, RSI has much higher efficacy at bottoms than tops. The momentum factor captured by RSI is suggesting high caution. A reading above 70 is not an automatic sell signal, but combined with the building divergence the warning bells are ringing. Tops form over much longer time frames.