PRO-EYES


Last Update: April 12, 2021

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

The overall PRO-II composite was up 3.4% last week and now shows the highest readings since a few points in 2019. The last time the composite indicator was this high it was followed by declines of 5-10% with a high probability. It was at similar levels in Jan 2020 as COVID was beginning to become a pandemic. We do not have the catalyst for a 35% correction with liquidity in markets, but a 10%-plus correction is a growing risk for US large caps in Q2-Q3.

VALUATION

Risk Level: 98%

Valuation remains extreme. History tells us that forward based returns will likely be far lower than average. It also suggests that periods of multiple contraction will bring with it larger than average corrections in market prices. In the coming weeks of Q1 earnings, we should see some valuations metrics improve as earnings play catch-up to markets, but unlikely enough to change the big picture. With markets running hot, the ERP is becoming more extreme. The primary justification for current multiples are cheap money. That thesis will likely get stress tested over the next year with debt supply likely forcing rates higher. Will the Fed step on the gas to offset the increased supply. That will be a huge factor in the back half of the year.

Enterprise Value to EBITDA

A reading of 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 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 near 100% historically means the average returns over the coming years will likely be well below average. While the market is extremely 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 near 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. The equity risk premium is the discount factor investors are paying for stocks above the risk free rate. The inverse of the P/E called the earnings yield plus the long-term government yield is a reasonable estimate. Overall, the ERP declined 7.2bps last week. The yield of the 30-year bond declined 2.7bps. The earnings yield of the S&P 500 declined 9.9bps. The last time the ERP was this low was in the period leading into the GFC.

BUSINESS CYCLE FACTOR

Risk Level: 64%

Weekly LEI jumped significantly last week as stimulus checks are hitting bank accounts and vaccines rollouts are progressing well. There are more near-term tailwinds than headwinds for now. We are watching global yield curves closely for signs of inflation. For now, the FOMC says bring it on, it’s all temporary. We could see headline inflation top 3% in the coming months while central banks will dismiss it as transient. THEY HAD BETTER BE RIGHT. The degree of moral hazard will make it near impossible for them to fight inflation without crushing the economy and the stock market with it. That will inevitably be the next big policy mistake. The Fed will talk the markets and economy up until they think it can be sustained, which they think is full employment in the 3.5% range, which is years away.

Slope of Yield Curve

A reading near 40% suggests a yield curve (3-months vs. 10-years) that is a bit steeper than average over history offering lots of liquidity. 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 steeper. Last week, the 3M-10Y curve was 5.6bps flatter.

High Yield vs. Investment Grade Credit Spreads

At a reading near 90% or more, 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 gnerally 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 4.02%, which is 2.1 standard deviations below average. Credit spreads are not yet showing important divergences from equity market trends, which is often a leading indicator.

NY Fed Weekly Leading Indicators

Over the past week, the NY Fed weekly leading economic index increased. The trend over the past month is rising while momentum is rising. The recent trend suggests evidence of strong growth. As cities are opening up and vaccines are rolling out at a faster than expected pace, higher frequency indicators improved significantly again last week. Stimulus check, while seeing a significant bump in savings, are making their way into spending. Historically, the Fed would be looking to take the “punchbowl” away, but they continue to reiterate a willingness to let it run hot. It’s only hot when stimulus is pedal to the metal. 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 -0.7bps. Nominal yields decreased -6.3bps, while inflation expectations fell -0.06% to 2.16%. Monetary policy is Highly Liquid. 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. Bond market stress is evident, and we are seeing different narratives from global CBs.

TACTICAL FACTOR

Risk Level: 73%

Overall the tactical factor was up 5% last week. While the S&P 500 made new highs, seasonal factors are still strong for the next several weeks and is outweighing (for now) overbought readings building in breadth and momentum factors. Falling volatility is a near-term positive as we have not hit complacent extremes yet. Sentiment readings from individual investors jumped significantly last week to extreme readings. A major sell signal is setting up and high caution is warranted.

5-Day Put/Call Ratio
Risk Level: 98%
The Put/Call ratio measures a degree of speculation and hedging in the options markets. A reading near 100% suggests an all-time extreme degree of speculation. The ratio of speculation in call buying relative to put protection remains elevated, but volumes have notably declined. The recent move higher in interest rates did not see a meaningful increase in put protection. The FOMC has our backs. “Buy the dips”, “Stocks only go up” when you start hearing these narratives understand you’re in a more speculative market with much higher risks.
Speculative Position S&P 500 Futures
Risk Level: 34%
Positions of speculators in the S&P 500 futures contracts offers a potential future source of supply or demand. Current readings are slightly positive, it’s when the position gets to an extreme that it becomes a contrary indication. As of April 06, S&P 500 E-mini speculators increased their net short position last week by 249.4 million dollars. If speculators get very long into earnings announcements, it would be a huge contrarian signal along side poor seasonals in May.
Percentage Deviation from 200-Day Moving Average
Risk Level: 98%
The deviation from trend is extreme. While it can persist over time, the extreme reading suggests a near-term correction is a very high probability. 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. A break of the January and February lows would suggest the opposite. Big picture those lows are extremely important if they break on a weekly close.
AAII Bull vs. Bear Sentiment Spread
Risk Level: 95%
Last week the percentage of bulls increased 11.1% while the percentage of bears decreased 2.8%. The last time we saw this extreme was Jan 2018 prior to the volatility crash. When the percentage of Bulls excedes the percentage of Bears by this amount, we are likely very close to a contrarian sell signal. We like to pair this indicator with sentiment of speculators in the futures markets, which is not yet confirming extreme positioning.
Seasonal Pattern (All Years) Since 1928
Risk Level: 42%
The 1-Month forward based return is slightly above average based on the 4-year presidential cycle model. The current factor is a modestly positive influence. Seasonal factors are generally positive during Q1 earnings period that often leads to a profit taking opportunity in Q2. April is one of the strongest months of the year on average.
Presidential Cycle (Current Year) Since 1928
Risk Level: 0%
The 1-Month forward based return is well above average and provides a good tailwind based on the current year of the presidential cycle model. During a presidential cycle year, we are near the psychological 100-day benchmark. This is not your typical cycle in terms of stimulus to be sure. However, the historical seasonals are extremely bullish for the next few months.
Current vs. Average Volatility (VIX)
Risk Level: 83%
Last week, volatility was -3.7% below the previous week. It was -20.5% compared to it’s 50-day average. The 50-day average is 8.0% above it’s long term trend. Volatility is likely to remain elevated with an active central bank distorting traditional valuation metrics. The recent decline in VIX below 20 (3 weekly closes) is a factor of liquidity and high optimism. It’s not at historic complacent levels yet. This will become an important factor in the next few months, but not yet.
Current vs. Future Volatility (VIX)
Risk Level: 87%
Last week, current volatility was -9.6% below the previous week. Future volatility was -2.9% below the previous week. The ratio of current volatility to future volatility is very depressed and complacency is a risk. Expectations of future moves in volatility (i.e. the volatility of volatility) can swing dramatically. It is a very good tactical factor for short-term swing trades. A sell signal tends to develop when expectations of future volatility are too low. Risks are notably elevated.
Percentage of S&P 500 Holdings Above 50-Day Average
Risk Level: 92%
The percentage of stocks in the S&P 500 above their own 50-Day averages is 89.9%, which is 4.0% above the previous week. It is 8.4% above the average of the past month. Current levels are showing very strong trends. When new highs are seen in markets as we saw again this week, we start to look for divergences in breadth indicators. Relative to the past 2 highs, more stocks are above their 50-day averages confirming new highs. This suggests correction risks, but a strong underlying trend with broad participation.
Percentage of S&P 500 Holdings Above 200-Day Average
Risk Level: 94%
The percentage of stocks in the S&P 500 above their own 200-Day averages is extreme at 95.2%, which is 0.8% above the previous week. It is 3.8% above the average of the past month. The breadth divergences that were building have now been negated by new highs in the percentage of stocks above their own 200-day averages as markets made new highs. But the extreme readings do not suggest we chase ATH.
Breadth-McClellan Summation Index
Risk Level: 71%
The breadth of the market is very good. Most 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 highs from December. This is an increasing negative factor if the markets cannot keep making new high in the coming months. Slightly different view here with broader markets than with the large cap S&P 500.
Overbought-Oversold 13-Week Relative Strength Index
Risk Level: 87%
The 13-week RSI is now extreme at 71. High 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 other metrics suggest defense and caution is warranted.