PRO-EYES


Last Update: February 23, 2024

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

The worst of the traditional February seasonal period has passed and that has mitigated the reading in the overall index to its most extreme readings since “Volmageddon 2018”. We have not seen a weekly RSI reading this extreme in years. The lift that NVDA and AI thematics are causing is extreme, but there is no timing a correction with precision. Historically, forward based returns from these extremes are negative looking out 3 to 6 months. The caveat is that we did not see a sell the news reversal on NVDA earnings like we did following the previous two earnings reports. The market may have enough options market gamma buyers to keep it grinding higher. The next big data point catalyst is the US PCE on Feb 29th if it has a surprise uptick, which few are expecting.

VALUATION

Risk Level: 88%

As we get through earnings period, forward based estimates are falling at the same time the market is moving higher. This, of course, makes little sense. It does suggest what is driving the markets higher is not fundamentally based, but flow based. Valuation remains extreme and history tells us the forward based returns are poor at this point in the cycle.

Enterprise Value to EBITDA

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. 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, depreciating and amortization. In other words, how much capital is used to generate free cash flow.

Price-to-Sales

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 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 70% historically means the average returns over the coming years may be somewhat below average. While the forward P/E is above average, historically, this metric suggests returns will likely be 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 versus the current forward P/E of 21.11. Over the past 3-months forward EPS estimates have increased by 7.52%. Over the past month, forward EPS estimates have increased by 1.57%. The rate of EPS change is slowing.

Equity Risk Premium

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 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 increased 63.2bps last week. The yield of the 30-year bond declined 6.5bps. The earnings yield of the S&P 500 increased 56.7bps. The tightening of financial conditions is likely to continue in the short run. But we are very close to fully pricing in the terminal rate of Fed funds and weakening of the economy and earnings should start to balance out. Markets remain on the expensive side, but it’s mostly because of higher rates.

BUSINESS CYCLE FACTOR

Risk Level: 88%

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 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 increased 63.2bps last week. The yield of the 30-year bond declined 6.5bps. The earnings yield of the S&P 500 increased 56.7bps. The tightening of financial conditions is likely to continue in the short run. But we are very close to fully pricing in the terminal rate of Fed funds and weakening of the economy and earnings should start to balance out. Markets remain on the expensive side, but it’s mostly because of higher rates.

Slope of Yield Curve

A reading near 100% suggests the yield curve (3-months vs. 10-years) is forecasting recession within the next 12 months. An inverted yield curve leads to credit contraction as lending profitability is curtailed. A curve this flat suggests financial conditions are extremely tight. The recent trend has been steeper. Last week, the 3M-10Y curve was 6.1bps flatter. The forward curve is pricing in only modest rate cuts by mid 2023. Powell launched the higher for longer narrative and we expect the curve to remain in recession mode until inflation clearly breaks. This restrictive curve could last into 2024, though the recent banking insolvencies can complicate the FOMCs job fighting inflation.

High Yield vs. Investment Grade Credit Spreads

At a reading near 80%, credit spreads are near extreme low levels and suggest easy financial conditions and a strong economic outlook ahead. Investors are not likely adequatly compensated for credit risks if a shock develops, but this is never a moment in time, but a process over weeks or months. Narrow credit spreads correlate with high business cycle risk when a shock develops. The yield-to-worst (maturity) for junk bonds is 7.87%, which is -1.0 standard deviations below average. The FOMC and other central banks are reducing liquidity and e expect them to maintain tighter financial conditions than equity markets are pricing for an extended period. Looking out, we should expect tighter financial conditions and wider credit spreads until the economy troughs. Over the past month, HY-IG spreads are -10bps narrower. Over the past 3 months, HY-IG spreads are -39bps narrower. Momentum is increasing.

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 at a faster pace. The recent trend suggests evidence of modest contraction. Growth challenges are significant without deficit driven stimulus. For more details see: https://www.newyorkfed.org/research/policy/weekly-economic-index#/interactive We are now past the stimulative phase of the cycle and looking ahead, quantitative tightening (QT) will likely provide a major hedwind for risk premiums. The labour market remains the stickiest part of the core inflation push with real assets showing signs of deflation.

Real Yields & Inflation Expectations

Over the past week, real 10-Year Treasury yields declined 0.0bps. Nominal yields decreased -3.1bps, while long-term inflation expectations fell -3.1bps to 2.57%. Real monetary policy is restrictive relative to long-term expectations. Short-term inflation numbers remain extremely elevated, while longer-term market based inflation expectations are elevated relative to the range of the past decade. Based on recent curve moves, the market has likely priced in more tightening than the FOMC actually will need to do given increasing odds of a recession.

TACTICAL FACTOR

Risk Level: 72%

In a presidential election year, the seasonals are strong in the back half and weaker in the first half. We expect the massive need to fund new debt with coupons will weight on markets in the first half. Yellen has proven to be a political operative fighting for her job. Interest rate risks and the impact on asset prices is likely a first half issue. With tactical risks highly cautionary, we continue to suggest a defensive bias to portfolios.

5-Day Put/Call Ratio
Risk Level: 72%
The Put/Call ratio measures a degree of speculation and hedging in the options markets. A reading around 70% suggests some degree of speculation. Last week, the average put volume declined 1,250 contracts per day while the average call volume declined 1,522 contracts per day.

Speculative Position S&P 500 Futures
Risk Level: 92%
Positions of long only speculators in the S&P 500 futures contracts offers a potential future source of supply or demand. Current readings are extremely elevated and suggests a high risk of stop loss selling. As of February 20, S&P 500 E-mini long only speculators increased their net long position last week by 373.0 million dollars. This group of long-only asset managers are as long as they have been since November 2021.
Percentage Deviation from 200-Day Moving Average
Risk Level: 93%
Deviation from trend is a sign of a strong market and a sign of an extreme condition. The current reading is very extended. The 50-day average is now above the 200-day average (Golden Cross), but the trend over the past month is weaker. The 200-day average held a key test last week. It must continue to hold or the bull-trend signal will turn bearish again.
AAII Bull vs. Bear Sentiment Spread
Risk Level: 78%
When the percentage of Bulls is above the percentage of Bears, the longer-term risk becomes high when it’s extreme. We are not there yet, but it’s getting very close. Last week the percentage of bulls increased 2.1% while the percentage of bears decreased 0.6%. There was a dramatic swing to bullishness after the FOMC Pause at the Nov 1 meeting. If inflation expectations remain high, this will fade as the FOMC will not cut rates.
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. The second half of year 3 of the presidential cycle tends to be weaker than most. We do not expect a strong Q4 under the weight of higher for longer pressure on all asset prices.
Presidential Cycle (Current Year) Since 1928
Risk Level: 92%
Positions of long only speculators in the S&P 500 futures contracts offers a potential future source of supply or demand. Current readings are extremely elevated and suggests a high risk of stop loss selling. As of February 20, S&P 500 E-mini long only speculators increased their net long position last week by 373.0 million dollars. This group of long-only asset managers are as long as they have been since November 2021.
Current vs. Average Volatility (VIX)
Risk Level: 93%
Deviation from trend is a sign of a strong market and a sign of an extreme condition. The current reading is very extended. The 50-day average is now above the 200-day average (Golden Cross), but the trend over the past month is weaker. The 200-day average held a key test last week. It must continue to hold or the bull-trend signal will turn bearish again.
Current vs. Future Volatility (VIX)
Risk Level: 57%
Last week, current volatility was -3.5% below the previous week. Future volatility was -2.1% below the previous week. The ratio of current volatility to future volatility is neutral. Volatility readings are swinging with the latest headlines. We expect elevated volatility readings as long as geopolitical risks are high.
Percentage of S&P 500 Holdings Above 50-Day Average
Risk Level: 68%
The percentage of stocks in the S&P 500 above their own 50-Day averages is 68.0%, which is 7.3% above the previous week. It is 1.1% above the average of the past month. Tactically showing good strength. It’s now been a few months since the market made its all-time high and so the opportunity for more stocks to break trend has developed. The 50-day average will cross below the 200-day average this week. Look for an oversold rally soon, but a move to new highs is unlikely until the reasons for the market corrections have been fully priced in. That could take a while given the rate hike cycle just started.
Percentage of S&P 500 Holdings Above 200-Day Average
Risk Level: 76%
The percentage of stocks in the S&P 500 above their own 200-Day averages is 76.4%, which is 5.5% above the previous week. It is 3.5% above the average of the past month. Statistically, breadth readings are oversold and odds of a rally are high once a catalyst develops. At this point we need a friendly FOMC and a significant reduction in geopolitical macro headwinds, which we do not expect in the near term.
Breadth-McClellan Summation Index
Risk Level: 73%
The breadth of the market is very good. Most stocks are participating in the advance. Overhead divergences suggests that a rally to new highs is unlikely. But there should be enough support buying dips as long as earnings fundamentals hold up.
Overbought-Oversold 13-Week Relative Strength Index
Risk Level: 72%
The 13-week RSI is now very extreme at 76. High caution is warranted. Overall, RSI has much higher efficacy at bottoms than tops. In the short run (days to weeks), extreme readings may carry momentum, but in the intermediate term (weeks to months), a high level of caution is warranted.