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Last Update: February 22, 2021

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

The tactical aspect of the model pulled the index down about 3% last week. It remains elevated in a cautious environment. The business cycle influence is keeping the index well below extreme levels seen pre-COVID due to central bank and stimulus. Artificial support for the economy is a growing part of longer-term structural risks. It supports the rampant speculation and leverage that is developing. Timing of which is impossible. Just understand risk factors are elevated.

VALUATION

Risk Level: 96%

Overall valuation metrics are EXTREME. Historically, valuation is not a good timing factor, but tells us about future average returns. At current levels, they are expected to be well below average with several periods of high negative returns. Corrections tends to be deeper when the economy weakens as both earnings contract and the multiple investors are willing to pay contracts. For conservative investors, once should have less sensitivity to economic weakness.

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 of 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 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.

BUSINESS CYCLE FACTOR

Risk Level: 55%

Overall the business cycle is completely distorted by central bank QE policy supporting the economy. Without it, the world would be in a deep depression. The biggest concern is the mispricing of financial assets and high yield credit in particular. With central banks actively seeking inflation, there is a tipping point for long duration financial assets leveraged to easy money. The Fed will have to keep stepping on the gas to keep business cycle conditions balanced at the risk of a STAGFLATION outcome.

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 steeper.

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 3.99%, which is 2.2 standard deviations below average.

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 falling. The recent trend suggests evidence of weak growth. Growth is weak at this point and there is a risk of dipping into a recession without additional stimulus. For more details see: https://www.newyorkfed.org/research/policy/weekly-economic-index#/interactive

Real Yields & Inflation Expectations

Over the past week, real 10-Year Treasury yields increased 19.5bps. Nominal yields increased 12.8bps. while inflation expectations fell from 2.13% to 2.06%. 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.”

TACTICAL FACTOR

Risk Level: 72%

Overall the tactical factor was weaker by about 6% last week. The cooling came as markets pulled back a bit from recent highs without any broad technical weakness. The more elevated the indicator, the higher the short-term correction risk will be. Divergences are building in breadth indicators and with the weekly RSI. This sign of decay suggests once a catalyst presents (stimulus funding, rising yields?), markets may be at risk for a 5-10% correction.

5-Day Put/Call Ratio
Risk Level: 99%

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.

Speculative Position S&P 500 Futures
Risk Level: 25%

Positions of speculators in the S&P 500 futures contracts offers a potential future source of supply or demand. At an extreme, it can be a meaningful influence. At current levels, it’s a positive factor for future demand as shorts may need to cover positions.

Percentage Deviation from 200-Day Moving Average
Risk Level: 96%

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.

AAII Bull vs. Bear Sentiment Spread
Risk Level: 80%

Last week the percentage of bulls increased 1.6% while the percentage of bears decreased 0.9%. When the percentage of Bulls excedes the percentage of Bears by a significant amount, many participants are invested and there is low cash left to buy. This is viewed as a contray indicator. It’s at a high spread, but it’s not yet extreme.

Seasonal Pattern (All Years) Since 1928
Risk Level: 69%

The 1-Month forward based return is below average based on the 4-year presidential cycle model.

Presidential Cycle (Current Year) Since 1928
Risk Level: 63%

The 1-Month forward based return is slightly below average based on the current year of the presidential cycle model.

Current vs. Average Volatility (VIX)
Risk Level: 59%

Last week, volatility was 10.4% above the previous week. It was -4.0% compared to it’s 50-day average. The 50-day average is 18.2% above it’s long term trend. Volatility is likely to remain elevated with an active central bank distorting traditional valuation metrics.

Current vs. Future Volatility (VIX)
Risk Level: 66%

Last week, volatility was 16.1% above the previous week. Future volatility was 1.9% above the previous week. The ratio of current volatility to future volatility is within normal ranges. 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.

Percentage of S&P 500 Holdings Above 50-Day Average
Risk Level: 63%

The percentage of stocks in the S&P 500 above their own 50-Day averages is 67.3%, which is 5.3% below the previous week. It is 2.2% above the average of the past month. Currently, intermediate breadth levels are a moderate positive factor.

Percentage of S&P 500 Holdings Above 200-Day Average
Risk Level: 88%

The percentage of stocks in the S&P 500 above their own 200-Day averages is extreme at 88.4%, which is 0.6% below the previous week. It is 0.6% below the average of the past month. Currently, longer-term breadth levels are extreme and weakening.

Breadth-McClellan Summation Index
Risk Level: 87%

The breadth of the market has been very strong. We are seeing extreme readings suggesting a near-term overbought condition. There is a developing divergence with highs from December. This is a building negative factor.

Overbought-Oversold 13-Week Relative Strength Index
Risk Level: 73%

The 13-week RSI is elevated at 65. Caution is warranted. Overall, RSI has much higher efficacy at bottoms than tops. The current market highs seen this month are showing a bearish divergence with the highs over the past few months.