Target Met

Back on September 5th I wrote about a potential intermediate term top in the DJ internet index here. As we know by now, topping patterns in strong uptrends are likely not to complete since you are going against the longer-term trend which is why this example was only a “potential”. But, all trends eventually end so they should not be ignored. In this case, the downside target down at “T1” was significant enough to grab my attention. Not evident from my chart, the internet index was forming a topping pattern warning of a move lower while the broader market continued to move higher, pointing to clear divergence.

Fast forward almost two months and here is what has transpired since the post. The price of the index eventually broke below the (red) support line and chopped sideways for a couple of weeks. From there it attempted a quick rally, back-tested the underside of (red) support and immediately failed.

As you can see, the index has fallen and currently sits right on the T1 target. This is an area that should act as support and as such would expect price to consolidate or possibly reverse higher. If you shorted the index on the setup, congratulations, I would be banking profits. Going forward if the index can hold support it will present a nice, reversion to the mean investment trade. If not, this index and likely the overall market is in deep trouble and set up for a larger move to the downside. In my humble opinion investors should be treading lightly here waiting for confirmation this is something other than a “potential” bottom before committing investment capital.

Paid Forward

The graphic below is a high probability snapshot into our stock returns future. The grey line is percentage (left vertical axis) of US households that own stocks. The red line is the subsequent SP500 total return (right hand vertical axis). The correlation between these two over the past 67 years has been very, very strong as you can see. The take away is the more US households that own stocks, the lower the subsequent 10-year return in the US stock SP500 index. This does make sense if you look at it from the context of supply and demand. The more people who already own stocks, the fewer households that are left to buy and drive prices higher. We are at the third highest level in the history of the dataset and at current levels, we can expect a 10 year forward return of a whopping 3%.  Ugh!

What could make this chart wrong? Not much as the correlation is too strong! But, a huge correction always takes care of too much stock ownership. Not a great solution you say? With the financial world continuing to expand globally, there are people from other nations who, in the past would not even be considered potential buyers but because of expanding worldwide wealth, are now added to the pool of potential investors in the SP500.  How much upside might that add, if any, is unknown.

The chart clearly shows that we have not yet reached other levels of extreme participation (and worse subsequent future 10-year returns) and as such we could move even higher. So, while all is not lost, the outlook for equity returns is becoming disappointingly uninspiring. We have pulled forward both demand and returns and by doing so have set ourselves up for a likely lackluster investment future.  I don’t want to be a Debbie Downer but being prepared for the high probability of the next 10 years being not a compelling investment environment should be some knowledge of great value. We either need to reset our expectations or change our investment approach if we want (or need) better returns.

A Few Questions to Ponder

The average country ETF is now down over 10% year-to-date. US large caps continue to mask global equity weakness as you can see in the chart below. Diversified global investors are likely down for the year.

If the take-away from this chart is a snapshot of investors global appetite for risk, what are the numbers telling you? Risk on or risk off? Do you think there is a higher probability to turn 41 countries into positive returns or 4 countries negative? With that in mind and in spite of the US holding on to year-to-date positive equity returns, this chart should be telling a tale of caution, at least for investors outside the US.

September 2018 Charts on the Move Video

The bulls were out in force as we closed out the third quarter. With the expected year end rally, 2018 looks to be another strong year for the market…. the US stock market. Bonds, commodities and foreign investments continue to under-perform and act as an anchor to portfolios. Mean reversion will eventually show up but, based upon the charts, Q42018 seems like more of the same.

My Q3 recap video can be viewed in the link below.

https://youtu.be/MgUbcV8Ckb8

Why You Trend Follow

Trend following is a simple concept that has proven itself time and again and across all different markets. In its simplest form, Trend following is a strategy whereby an investor should buy an asset when its price is trending higher and sell when its trend reverses down, in either case expecting price movements to continue. Why this works is because like most things, investments trend.  Of course there is the details to work out as to identify when trends start and end but that is for another post.

When looking at its chart, it’s easy to see why an investor would want to invest in the Russell 1000 stock index (the largest 1000 US stocks). It has been in a clear uptrend since its 2009 bottom, rising more than 420% over the past 9+ years.   

It just so happens that some marketing genius has sliced the same Russell 1000 index into both a “value” and “growth” component thereby providing 3 of the same (but slightly different) flavors of the Russell 1000 index. I have plotted each in the graph below.

The green line is Russell “Growth”, blue is the entire 1000 stock index and the laggard, red, is “value”. We know historically during strong bull market up-trends there is proven out-performance in owning a larger growth component in a portfolio which is holding true during this uptrend. As the bull market wanes and we get closer to the end an economic up cycle, “value” typically begins to lead “growth”. To put it in perspective, in the case of the Russell, so far “growth” has outperformed the overall index by 70% and “value” by 130% over the same 10 year period. The question an investor needs to answer is why own the broad index or value when Russell growth is leading the trend? Most of the time the answer investors use is because of diversification or they don’t know how to find those that are out-performing. In my mind, those is poor reasoning. Aren’t we investing for one reason and one reason only? To make the most amount of money.

So what we can learn from this very narrow (but representative) look at the US stock market is 1) we are still in a strong bull market 2) trends last longer than one expects (which is why we want to be trend followers) and 3) trend following can provide a clear out-performance advantage over general index investing.