We have remained positive on US equities all year. Despite a continuation of the Fed’s rate hiking cycle, extreme valuations, Donald Trump’s questionable presidency, and more recently the threat of nuclear war and devastation of Hurricane Irma… the S&P 500 has continued to make a series of record highs.
It often pays to be a contrarian when investing. However, there are times when being contrarian will get you killed, and it pays to be a friend of the trend. The fact is that throughout the current expansion, without debating the reasons for it, many investors (particularly hedge funds) have been underinvested. This has been one of the greatest bull markets in memory, returning over 270% since the 2009 low.
I’ll concede that I at times have been skeptical of the rally, and perhaps in conformity with many of my peers, would have ‘welcomed’ a sell off in place of a continuation of the up trend. But in recognizing this, and being opposed to what my process was telling me, it became clear that this was not going to achieve what successful investing is all about: making money.
I’ll now share with you the systematic process that has kept us invested in equities against bearish consensus amongst fellow professionals. In this case we are looking at US equities, but we use similar versions to assess major currencies and commodities including crude oil and gold, and score each factor +1, -1 or 0 depending on whether they are positive, negative or neutral for the coming month. A positive total score indicates a potential buying opportunity, and a negative score suggests that you should look to sell (closing long positions or going short). A neutral score suggests avoiding trades when there is no clear bias in order to preserve your capital.
Bond/equity yield ratio. The relative bond/equity yield has ticked down, meaning that equities are becoming more attractive versus bonds at the margin. The 4.1% yield offered by equities is greater than bonds at 2.2% and is seen as a positive on our checklist. (+1)
Economic activity. The ISM Manufacturing Purchasing Managers Index is well above 50, which is definitely positive for stocks. However, we did see a tick down from the top of the range this month which means we have a positive level, with a little negative momentum. If this were to tick down again next month, then we might consider this a ‘0’, but for now we see this as a small positive and award a half mark. (+0.5)
Earnings estimates. Analysts continue to raise their earnings forecasts for S&P 500 companies. This remains a positive for equities this month. (+1)
Valuation. In terms of valuation, stocks remain expensive. At 17.4 times next year’s projected earnings, the equity market is richer than the 5-year and 10-year average of 14x and 15.4x respectively. This is a reason to be negative on the expected returns for the equity market. (-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). This month there is a balance between red and green and this is therefore seen as neutral on the 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 as contrarians, meaning that we view fear as an opportunity to buy, and complacency an opportunity to sell. This month there is more red than green on the scorecard, with a sum of 2 suggesting that we should have a slight bias towards buying equities this month based on this alone. (+1)
Technical analysis. The bull market is clear to see in the first chart, even to the most stubborn bears. In terms of shorter-term support & resistance levels, the e-mini S&P 500 futures ('ES') contract has no obvious overhead resistance until 2608; a projected move we have been following since the election of Donald Trump in November 2016. There is no reason why the market should fail to at least test this level, and a retracement towards 2300 in the interim would likely provide a buying opportunity around support. (+1)
In total we arrive at a score of +3.5 heading in to September, which the most positive score we have observed in equities all of 2017. Our checklist provides an objective reference for what we should be looking to do as investors based on facts, not opinions. This suggests remaining long US stocks during September.
Hopefully this offered useful insight in to how we have remained on the right side of the equity market in 2017.
Have a great week trading,
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