This article illustrates how we can reach valuable investment conclusions in a forward-looking way by using a comprehensive investment research process. It shows how investment strategy should cover political and economic developments, the bond market, stock market conditions, sector rotation, and data on individual stocks, all in an integrated way.
The case study shows an assessment of the market in early October 2018, just before stocks plunged into a sharp correction in the fourth quarter of 2018.
In September 2018, the price of the S&P 500 was in the 2900 range, and many on Wall Street believed it would continue to climb higher, with price targets for year-end 2018 in the range of 2900 – 3200. This scenario seemed plausible and could be supported by a number of bullish arguments.
Yet by late December 2018 the S&P 500 fell to a low of roughly 2350, a decline of almost 600 points, or 20% down from its September high. For the fourth quarter of 2018, the S&P 500 experienced a price decline of 14%.
Figure 1 S&P 500 – 2018 (daily)
In early October 2018, the prudent strategy was to reduce equity exposure and make changes in sector weights, reducing positions in technology stocks while moving to an overweighted position in defensive sectors such as utilities and consumer staples.
We could reach these conclusions in early October 2018 by performing a comprehensive market review. This weekly market review, as of October 5, 2018, is shown below.
Note: this case study is not an exercise in 20-20 hindsight. It is an example of analyzing the market in a FORWARD-LOOKING WAY. It is entirely based on data that was available on October 5, 2018, BEFORE the market plunged. It illustrates general principles of market analysis, such as assessing risk / reward conditions, identifying signs of a market peak, and coordinating market conditions with the stock selection process.
Summary of Economic and Market Conditions – Week Ending Friday, 10/5/18
• Global Macro: Rising tensions with China, growing uncertainty about the upcoming November 2018 U.S. midterm elections, and worries that rising labor costs could cause a pickup in inflation.
• Federal Reserve: On 10/3/18, Fed Chairman Jerome Powell made hawkish comments, stating “we’re a long way from neutral, we may go past neutral.” This raised major concerns that the Fed would make a policy mistake and tighten too much.
• Other Markets: Bond prices plunged through support levels, bringing 10-year Treasury yields up to 3.20% (see Figure 2 below). (Note: bond yields soon came back down, but in October 2018 there was talk of yields rising to 4.0%).
Figure 2 First week of October 2018 — Bond prices dropped as yields shot up to 3.20%
Stock Market Technical Condition:
Overbought / Oversold: the stock market had been rising steadily for the past 6 months (April through October 2018). It had become overbought and overdue for a pullback.
Price / Volume activity: Figure 3 below provides a detailed look at the market’s daily price and volume activity over the last few weeks.
Figure 3 As of 10/5/18 — Daily chart of Nasdaq shows numerous bearish signals
Note: in general, large red bars on big volume are bearish because they show institutional selling pressure (more detail is provided in the full report).
The number of “distribution days” in the last few weeks had reached 9, a very high level. (A distribution day is essentially a big down day on big volume. More than 6 or 7 of these days within a month shows institutional selling and is a bearish sign for the market.) Acknowledgement: this method of identifying market peaks is a key principle developed by Investor’s Business Daily.
Support / Resistance: On 10/4 and 10/5/18, the Nasdaq plunged through two major support levels on big volume: its 50-day moving average and its prior low (as shown in Figure 3). These are bearish developments.
Breadth / Divergences:
The Advance / Decline line fell below its 50-day moving average for the first time since March 2018.
Another breadth indicator, the percentage of stocks above their 40-day moving average, was dropping sharply, forming a bearish divergence with the S&P 500.
… These and other indicators show that the market was very weak beneath the surface.
Sentiment:
Investors Intelligence survey: 62% Bulls, only 19% Bears. Investor sentiment was still very optimistic, showing complacency – this is bearish.
To summarize the market situation as of Friday, 10/5/18:
1) Political uncertainties and geopolitical tensions were rising
2) The Fed just turned surprisingly hawkish
3) The bond market sold off sharply
4) The stock market was overbought
5) The stock market was showing alarming signs of weakness beneath the surface
6) Market indices plunged through support levels on big volume
7) Sentiment showed excessive optimism.
This review of economic and market events showed that numerous bearish developments unfolded in the first week of October 2018, meaning that the market’s risk / reward condition had deteriorated sharply.
The weight of the evidence leads to a bearish conclusion.
Therefore the prudent course of action in this situation would be to reduce equity exposure, or take other defensive action in managing client portfolios.
In the second week of October 2018 (the week after the analysis shown above), the market plunged, and stocks went into a sharp correction that continued throughout the fourth quarter of 2018.
Note that in order to adopt a more defensive investment posture when the S&P 500 was roughly 2885, before it dropped to 2350, we did not need to predict a new target price of 2350. We just needed to assess the situation as of 10/5/18 and realize that the market environment had become much more risky.
This example shows the importance of performing a comprehensive market review on a weekly basis. In September 2018 the market outlook had appeared generally positive, but then numerous bearish developments unfolded in the first week of October 2018.
Following a weekly routine like this enables us to stay on top of developments and make investment decisions in a forward looking way.
Note how the analysis shown above was based on both macroeconomic fundamentals and technical indicators. In addition to studying the economy and the Fed, we also need an assessment of the market itself. The technical picture plays an important role in the analysis. Sometimes the market shakes off bad news and acts well despite bearish fundamentals.
However, as of 10/5/18, there was plenty of evidence that after a six month uptrend, the market was now showing signs of a change in trend, from an uptrend to a downtrend.
Coordinating Market Conditions with Sectors and Stocks
• The type of market condition can also lead to additional conclusions with regard to sector weights.
• My research shows that changes in sector rotation often coincide with turning points in the overall market.
• Thus in early October 2018, when our analysis showed that the market was peaking, we should adjust our sector weights.
• The general principles for this type of market situation would be to reduce weightings in sectors that have become overbought and are showing signs of turning down, while moving to an overweight in defensive sectors such as utilities and consumer staples.
• Major changes in market conditions and sector rotation also influence decisions on individual stocks.
• At any given time, probably at least 450 of the 500 stocks in the S&P 500 will have “Buy” ratings from analysts who can make a bullish case for the stock based on the fundamentals. If almost every stock is a “Buy,” we need another level of analysis to determine which ones are likely to outperform.
• Thus the stock selection decision should consider the condition of the overall market (such as overbought, oversold, in an uptrend, in a correction, etc.) as well as sector rotation.
• To address these issues, I have formulated a general set of rules or guidelines for what actions to take in various market situations.
• Note: analyzing market relationships with this rule-based approach, as opposed to using statistical methods such as regressions and correlations, is one of the valuable and proprietary features of this investment research process.
Charts and Data for Sectors
The weekly investment routine also involves analyzing sectors and industry groups with additional charts and data.
• For additional sector analysis, we can review both technical and fundamental data on sectors and industry groups. To do this, I have built complex data management procedures covering over 1,100 stocks and ETFs. This analysis provides valuable information on sectors, industry groups, and individual stocks.
• This data is updated every week in a large spreadsheet which contains data for all sectors and industry groups.
• Examples are shown in Figures 6 and 7, which show selected sections of the spreadsheet from 10/5/18.
• Figure 6 shows data for the technology sector, both for the sector as a whole and some of its industry groups.
Figure 6 Technology Sector — Technical and Fundamental data for the week of 10/5/18
Explanation of this data:
• Fundamental data is shown in the two columns on the right. It is from a quantitative stock selection model which is based on fundamental factors such as earnings growth and earnings estimate revisions.
• All the other columns show key technical developments. They indicate what percentage of stocks in each industry group are forming specific technical patterns.
• The data in Figure 6 shows that as of 10/5/18, many technology stocks were forming bearish patterns such as falling below their 50-day moving averages, or dropping sharply on big volume. This provided additional confirmation that the technology sector was peaking.
• By comparison, despite the general market weakness, data for the utilities sector was more positive. Many utility stocks were showing bullish technical signals such as improving relative strength, and also had bullish fundamentals.
• This meant that the utilities sector was relatively attractive as of 10/5/18, as seen in Figure 7.
Figure 7 Utilities Sector — Technical and Fundamental data for the week of 10/5/18
What is the value of this data management process?
Performing this comprehensive review of technical and fundamental data, updated weekly, allows us to consistently stay on top of market developments, and to see what is going on beneath the surface of the market.
It is designed to spot patterns of major institutional buying and selling in sectors and industry groups.
This process aligns technical data with fundamental data. It provides valuable insights into the status of sectors and industry groups, based on both technical and fundamental data.
Based on years of experience with equity quant systems that rank stocks on a scale of 1 – 100, this approach has much more practical value.
Note: The data shown in Figures 6 and 7 is not a “system.” We do not blindly buy or sell stocks based on this data. These spreadsheets are a tool which give us insights into the behavior of sectors and industry groups. We review this data as part of the weekly investment process. If certain areas of the market appear attractive or unattractive based on this data, we then study them in more detail, and combine them with additional information, as part of a complete market analysis.
Identifying Individual Stocks to Buy and Sell
The last step in this weekly research process is to identify individual stocks that are good Buy or Sell candidates.
Examples from the week of 10/5/18 are shown below:
As of 10/5/18, American Electric Power (AEP) was a good BUY candidate, for the following reasons:
- Overall market conditions – risks of a correction are rising, and safe, defensive stocks tend to outperform in market corrections.
- Good sector – the Utilities sector is one of the only areas of the market showing technical “Buy” signals at a time when the overall market is weakening (Figure 7).
- Good industry group – the Regulated Electric group is one of the only strong areas in the market.
- Good technical position – the stock just formed two technical “Buy” signals despite the weak market.
- Good fundamentals – AEP is rated “Very Bullish” by the fundamental quant model.
As of 10/5/18, Netapp (NTAP) was a good SELL candidate, for the following reasons:
- Overall market conditions – risks of a correction are rising, meaning that former market leaders could be subject to profit-taking.
- Sector is peaking – the Technology sector is now showing a breakdown in relative strength and other bearish characteristics (Figures 5 and 6).
- Industry group weakness – the Data Storage group is now showing numerous “Sell” signals.
- Bad technical position – NTAP just formed a “Sell” signal, breaking down through its 50-day moving average.
- Poor fundamentals – NTAP’s rating from the fundamental quant model just turned to “Very Bearish” in the week of 10/5/18.
REVIEW OF THE 10/5/18 ANALYSIS
Now that we have covered the entire investment process including analysis of the overall market, sector rotation, and individual stocks, we can review what happened after this 10/5/18 market analysis.
The Overall Market:
As shown above in Figure 1, the stock market plunged in the fourth quarter of 2018.
As outlined above, numerous warning signs of a market peak were evident in the first week of October 2018, before the market plunged.
Sector Rotation:
The weekly assessment of overall market conditions feeds into the analysis of sectors and stocks.
Based on the analysis shown above, our conclusion was to underweight the technology sector while moving to an overweight in utilities and other safe haven sectors.
In the fourth quarter of 2018:
The S&P 500 declined by -14.0%
The Technology sector (XLK) dropped by -17.7%
By comparison, the defensive sectors outperformed:
The Consumer Staples sector (XLP) declined by only -5.8%
The Utilities sector (XLU) had a gain of 0.5%.
Thus, even if no changes were made to asset allocation, significant outperformance could be created in the fourth quarter of 2018 simply by shifting to an overweighted position in safe sectors such as Utilities and Consumer Staples.
Individual stocks:
The analysis shown above suggested buying American Electric Power (AEP) as of 10/5/18. The stock subsequently outperformed the market, with a gain of 5.4% in the fourth quarter of 2018 (vs. a decline of -14.0% for the S&P 500).
The analysis also suggested selling Netapp (NTAP). The stock then declined by -30.5% in the fourth quarter of 2018.
Therefore, making only one or two such changes to a portfolio (selling NTAP and replacing it with AEP) in early October 2018 would have made a significant contribution to one’s investment performance relative to the S&P 500 in the fourth quarter of 2018.
This example shows how portfolio strategy can be done in a forward-looking way, identifying stocks to buy before they go up, and identifying stocks to sell before they go down.
The fundamentals play an important role in the stock selection process. AEP had good fundamentals, whereas NTAP had poor fundamentals. As mentioned above, these fundamental ratings are based on factors such as earnings growth and earnings estimate revisions, thereby providing a good summary of a company’s changing fundamental outlook.
But instead of relying on the fundamentals only, this approach is also viewing the stock selection process within a larger context.
It is aligning the fundamental ratings with four other major considerations:
- the condition of the overall market
- the sector
- the industry group
- the stock’s technical position.
The combination of all this analysis is what makes this a powerful methodology.
It leverages the information from the fundamental quant system by combining it with other elements of market activity.
Note: By late December 2018 it was clear that another major change in market strategy was necessary.
By late December 2018 the market had become extremely oversold (see chart below) and in early January 2019 there were clear signs of an upturn. Thus as 2018 came to an end and 2019 began, we could recognize that market conditions had changed dramatically from the early October 2018 situation, and that it was time to make another round of changes to our investment posture.
Figure 8 The market was extremely oversold by late December 2018
CONCLUSION
This example shows that investment strategy does not require a Ph.D. in economics or statistics. It does not require a large research department. It can be done with a few good software packages and databases, many of which have a very reasonable cost these days.
With the right tools and procedures in place, we can monitor the whole mosaic of economic and market activity, put together the pieces of the puzzle, and draw investment conclusions in a meaningful way.
Note: the discussion shown above is from a larger report entitled “Investment Strategy Case Study: October 2018.” For a copy of this report, or to discuss how to put this investment process to work for you, please contact Jonathan Strauss, CFA:
jon@straussresearch.com 513 – 379 – 2792 (cell / text)