They say “sell in May, and go away", yet equities remain within 1% of the record closing high set 19th June. Despite the endless chatter from talking heads in the financial media, there are no signs of an imminent correction entering July.
Of course, nobody can predict the future, and admittedly seasonal factors tend to exhibit weakness in equities during the summer months. However, the checklist that Lex and I present in our monthly Trading Club meetings suggests otherwise, and our experience tells us that we should focus on this over the noise of other opinions.
Our checklist demonstrates a systematic process that fellow hedge fund managers and traders employ to analyse markets, from which the big trading decisions are based. In this case we are looking at US equities, but we use similar versions to analyse major currencies and commodities including crude oil and gold.
There are 7 factors that we score +1, -1 or 0 depending on whether they are seen as positive, negative or neutral for equities in the coming month. The total ranges from +7 to -7, with a positive score indicating that stocks should be bought, and a negative score suggesting that you may look to sell (closing long positions or going short). Sometimes of course there will be a neutral total of 0 - which in itself can be valuable in protecting your P&L by avoiding trades when there is nothing to be done.
Bond/equity yield ratio. The relative bond/equity yield has ticked up, meaning that bonds are becoming more attractive versus equities at the margin. Although the 3.8% yield offered by equities is greater than bonds at 2.3%, we are more interested in the momentum than we are the absolute level, and therefore score this as negative on our checklist (-1).
Economic activity. If I were trading equities from a desert island with only one indicator, this would be it! The ISM Manufacturing Purchasing Managers Index is well above 50 and has rebounded to the top of the range - definitely positive for the stock market (+1).
Earnings estimates. Whilst some people are bemoaning the growth picture for earnings next year, I dont see it in this chart! The trend is clearly upward and supportive of equities (+1).
Valuation. After that more cheerful news, we arrive at the elephant in the room. Stocks are expensive. As you can see, at over 17x next year’s projected earnings, the equity market is richer than the 5-year and 10-year average of 14x and 15.3x, respectively. This is a reason to be negative on stocks (-1).
Leading indicators. The leading indicators we monitor are compiled in a scorecard that we provide every Monday in our weekly market report. These are a basket of measures from various markets, including equities, commodities and even sovereign Credit Default Swaps (CDS). Without going in to detail here (we explain each of these in exhaustive detail in our course), there is a balance between red and green and this is therefore neutral for our checklist (0).
Sentiment indicators. After the leading indicators we always take a look at sentiment. Particularly if you are a shorter-term day trader, you must be aware of how other participants are positioned and ‘feeling’ at any given point. Naturally, we view these factors from a contrarian standpoint, meaning that fear presents an opportunity to buy, and complacency an opportunity to sell. This month we have the strongest indication possible that stock investors are fearful which we regard as nothing but positive (+1).
Technical analysis. Technicals are an important part of our process, but come last and do not preside over anything we have seen so far. However, the trend is clearly up and this remains a bull market for US stocks. If you have been short the market you would have made considerably more being long!
In terms of shorter-term support & resistance levels, the e-mini S&P 500 futures ('ES') have completed their projected move towards 2455 which we have been following since the US presidential election of Donald Trump was announced in November 2016. There is no reason why the market should fail to clear this level, and any retracement towards 2300 would likely provide a buying opportunity around support.
Summing everything up, you can see that we arrive at a total score of +2 on our US equity market checklist as we head in to July. Whilst the talking heads and financial weathermen may be oblivious to the facts, by following our process you can ensure that you are on the right side of the market and prepared to take advantage of any opportunities to buy stocks in the weeks ahead.
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