Is the Stock Market a Bug in Search of a Windshield?

Years ago, my friend John Mauldin described the Japanese yen market as a “bug in search of a windshield.” Some have said that John coined the phrase, and it was the first time I had heard it. But in 1974, Genesis on their last record with Peter Gabriel used a similar phrase: “And I’m hovering like a fly waiting for a windshield on the freeway.”

As the market has weakened in the last few weeks, and the news has seemed darker, with the political rhetoric turning more extreme and strident, I’ve felt this suspension of momentum that makes me wonder if the stock rally that we have been blessed with for the last eight months is coming to an end.

I’m sure many of you have felt the same way.

Perhaps you are wondering if a substantial decline is waiting at the next crossroad ahead. I wouldn’t blame you if you were.

The stock market experienced its second weekly decline last week. (Yet, the S&P 500 has declined only 2.2% since it topped out on August 7, 2017. The NASDAQ has followed suit with just a 3.02% drop since its July 25 top.)

While earnings were generally positive, the percentage of firms reporting better-than-expected results was smaller than it has been during the rally.

The perception seems to be that the government is at a standstill and all of the President’s agenda has been halted.

Protesters have increasingly been turning to violence. Neither property nor human lives have been spared.

All of this has increased the level of financial uncertainty. And uncertainty normally breeds volatility and price declines.

To make matters worse, we are entering the period of the year where stocks decline and the market becomes its most volatile.

S&P 500 Average Absolute Daily % Change by Trading Day of Year

All of these things are factual. They are not fake news. And, as observers of the passing scene, we have the right to feel that we may be heading for a SPLAT on the windshield of financial life.

But the operative word here is “feel.” As individuals, we all go through emotional highs and lows. And as a group, investors experience the same kind of roller-coaster ride. One look at a chart of a stock index or even consumer confidence demonstrates this.

University of Michigan Consumer Confidence

Yet, I learned a long time ago that what I feel has no connection with what will happen. One learns the hard way as an investor that the financial markets couldn’t care less about what any of us feel. It does not enter into the equation. In fact, if you were to invest according to your feelings, my experience suggests that doing the opposite of what you feel is actually more often profitable.

There are plenty of facts that permit a feeling counter to the impending doom that seems to pervade markets of late.

The decline has taken stocks lower, it’s true. But that decline is from record heights. The drop has driven prices into oversold territory (more than one standard deviation from their 50-day moving average).

S&P 500 Last Three Years

Typically, when that has occurred over the past three years, stocks soon reverse direction and climb higher (see the areas where the thick, dark-blue line sinks into the green zone in the chart above).

The Bespoke Investment Group points out that it has been 196 days since the S&P 500 last dipped into oversold territory. In its almost 100-year history, the Index has only been oversold for more than 150 days 16 times.

How has it done when this occurred in the past?

In all 16 cases, stocks were higher three months later! The average gain was 4.8%.

Continuing on this brighter note:

  • While earnings have not been outperforming, reported corporate revenues have actually been beating expectations at a higher rate than they have been in recent years.
  • Similarly, economic reports, which have been underperforming, have turned more positive. Of the 20 reports released last week, only five were below expectations.
  • Inflation is running so far below Federal Reserve Board expectations that thoughts of a further increase in interest rates seem to have been placed on an indefinite hold.
  • While things seem stalled in Washington, much is happening. Whether you view them as positive or negative, it is noteworthy that the President is issuing new presidential directives that are in pursuit of his goals almost daily. And did you know that there are more than 270 bills that have been passed by the House of Representatives this year? Of course, fortunately or unfortunately, depending on your point of view, they are awaiting Senate action.
  • While short-term indicators remain bearish, suggesting more declines may lie immediately ahead, the intermediate-term factors continue to point to higher prices, and the strategies based upon them remain largely fully invested.

Still, we know that declines have to start somewhere, and usually they are not anticipated. When the market is near its high and uncertainty seems pervasive, we often fear the worst.

The funny thing is that we think times like these are special or singular, but in reality, the stock market, other financial markets, gold, and even bonds are always in that moment. They can peak and then turn lower at any point in time. As I have said before, risk is always with us.

While the bugs may mess up our financial windshields and require some cleanup, you can avoid a wipeout like the bugs experience. That’s the aim of quantified, dynamic, risk-managed investing.

I look forward to many more bug-free miles with you on the road to prosperity.

Weekly Edge: Tactical Military Stocks on the Rise

Defense stocks rose amid news of the continuation of U.S. presence in Afghanistan. Companies such as Northrop Grumman, Lockheed Martin, and Boeing directly benefited from the speech. Since the U.S. presidential election, Boeing stock has risen 31%. The S&P 500 aerospace and defense index has also done well, increasing 21% since the election—almost double the returns of the general market. In short, with Trump focusing on the U.S. military, the military sector is expected to profit for the duration of his administration.

Sectors: The leading Sector Benchmark ETFs exhibited relatively major shifts over the past week. Utilities rose, and Technology and Financials fell significantly. Momentum scores of most sectors decreased for the week. The exceptions were Utilities and Materials. Real Estate, Industrials, Telecom, and Discretionary fell into the red. The spread between the highest and lowest increased from 42 to 54. In terms of ranking organization, there appears to be no general trend between cyclicals and defensive sectors. Technology (a highly cyclical sector) performed as well as Utilities (a typically defensive sector). Materials was the only sector to change from negative to positive for the week, suggesting a slight reversion for a potential slowdown in the economy. That, coupled with an overall decrease in momentum for each sector (except Utilities and Consumer Staples), also suggests the potential for a market slowdown.

We appear to be approaching a potential inflection point in the market. Utilities and Consumer Staples were the only sectors to increase momentum last week, while Energy and Discretionary are at the bottom of sector rankings. Overall, a slowdown seems to be more likely than a continuation of the momentum that we’ve seen for the year so far.

There are some specific concerns for certain sectors that may be affecting their rank. The overall lower price of oil has caused the Energy sector (typically cyclical) to continue to fall near the bottom of the rankings, from -24 to -33.

Factors: The leading Factor Benchmark ETFs did not fare well this week. Momentum and Low Volatility are the top-ranked factors, and High Beta and Small Size are still at the bottom. Risk-off factors such as Quality and Yield are concentrated in the center of the rankings, but Low Volatility has moved up. However, Momentum typically continues to work as a factor until the market shifts as a whole, while Small Size has a tendency to lead the market, suggesting a warning moving forward. The overall momentum ranking for all factors decreased last week, with the average momentum score changing from 5.5 to 0.6. The spread in values stayed the same at 29, suggesting the top-ranked factors and the bottom-ranked factors from the previous week are both idle.

Global: Rankings in the leading Global Benchmark ETFs are also less clear about the sentiment of the market. Emerging Markets, China, and Latin America still lead the rankings, and their momentum scores have risen for the week. China’s momentum score rose from 35 to 42, while more developed markets such as the UK fell from 3 to -1. The average momentum score globally increased from 14.9 to 15.5. The US was second from the bottom in terms of absolute rank. In developed markets, the US decreased the most, from 7 to 2.

Two week Edge Chart 08/23/17

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