THE “STATE OF THE MARKETS”…

In an effort to make my weekly review of the state of the market models easier to digest, I am making some adjustments to the report.

For those readers who like to stay on top of what the market “is doing,” but don’t enjoy digging into the guts of all the market models/indicators, I suggest a quick review of the Primary Cycle board. These models represent some (but not all – I’ll be upgrading the board in the coming weeks) of my favorite big-picture market models. As such, I’ve moved this indicator board – as well as this “executive summary” – up to the top of the report to make it easier to get the “bottom line.”

In looking at the Primary Cycle models this week, it is clear that there is a lot of green on the board and that the historical returns are strong. But (you knew that was coming, right?), I believe there are some “yea, buts” to consider this week. For example, the State of the Tape Model, while positive, has weakened a fair amount over the past two weeks (this despite a fresh all-time high for the S&P 500). And then the External Factors Model is currently sitting, quite literally, right on the line between positive and negative.

So, my take here is that while my market models/indicators are still in pretty good shape overall, I don’t see the “state of the market” being as positive as some of the boards might lead one to believe.

My Bottom Line: It’s a bull market until proven otherwise and the dips should continue to be bought. But, in my opinion, this is no time to have your foot to the floor.

THE STATE OF THE BIG-PICTURE MARKET MODELS

Let’s start with my “executive summary” of the state of the market – I.E. a review my favorite big-picture market models, which are designed to tell us which team is in control of the prevailing major trend.

Executive Summary:

• The Leading Indicators model, which was our best performing timing model during the last cycle, popped back up into positive territory last week. In short, I breathe easier when this model is positive. 
• We have recently upgraded our “State of the tape” model to include an additional 5 indicator readings. The current reading of the new model is has slipped to moderately positive. While not a reason to get defensive, this is indeed something to keep an eye on in the coming weeks/months. 
• The Risk/Reward model continues to wrestle with negative sentiment readings and the weakening monetary environment. As such, the model is stuck in neutral. 
• The newly expanded External Factors model includes a total of 10 indicators ranging from earnings, yields, sentiment, monetary, economic, and volatility. The current model reading is technically positive, but is currently sitting, quite literally, on the line. So, this too is something to watch.

THE STATE OF THE TREND

Digging into the details, I like to start my weekly review with a look at the “state of the trend.” These indicators are designed to give us a feel for the overall health of the current short- and intermediate-term trend models.

Executive Summary:

• The short-term Trend Model starts the week in positive territory, but only by a modest margin. While this may sound odd with the S&P finishing at a fresh all-time high on Friday, there is resistance overhead from a short-term perspective and only modest support. 
• Both the short- and intermediate-term Channel Breakout Systems remain positive and on buy signals. 
• The intermediate-term Trend Model starts the week positive once again.
• The long-term Trend Model hasn’t budged and continues to sport a bright shade of green at this time. 
• The Cycle Composite points to sloppy action over the next two weeks. 
• The Trading Mode models continue to suggest the market is trending.
• The recent sloppy action in the market was to be expected and the blue chip indices remain in good shape. However, the semiconductors bear watching in the near-term.

THE STATE OF INTERNAL MOMENTUM

Next up are the momentum indicators, which are designed to tell us whether there is any “oomph” behind the current trend.

Executive Summary:

• The short-term Trend and Breadth Confirm Model has flip-flopped between positive and neutral several times over the past two weeks – but is positive to start the week here. 
• Our intermediate-term Trend and Breadth Confirm Model has been a very strong indicator of the overall trend and remains positive. 
• The Industry Health Model continues to waffle in moderately positive territory and refuses to break into on outright bullish mode. 
• The short-term Volume Relationship is positive to start the week, but only modestly so. I’ll be watching this situation closely for signs of a breakdown in market internals. 
• The intermediate-term Volume Relationship remains in pretty good shape. My only complaint here is that Demand Volume peaked in March and remains well below the highs. A technical breakdown here would be worrisome. 
• Since the Price Thrust Indicator is an oscillator, it is not surprising to see the model reading backing off here – but still positive. 
• The Volume Thrust Indicator remains neutral this week. 
• The Breadth Thrust Indicator also slipped back to neutral this week. However, note that the historical return of the market when in this mode is well above average.
• In sum, market momentum is in decent shape. But I do see some weakness creeping in.

THE STATE OF THE “TRADE”

We also focus each week on the “early warning” board, which is designed to indicate when traders might start to “go the other way” — for a trade.

Executive Summary:

• From a near-term perspective, stocks worked off the persistent overbought condition and are now coming off a neutral reading. 
• From an intermediate-term view, stocks remain overbought – although the condition is not nearly as extreme as it was in November. 
• The Mean Reversion Model continues to waffle back and forth within the neutral zone as market volatility hasn’t been high enough to trigger a signal since mid-October. 
• The short-term VIX indicator’s sell signal is now quite stale. However, there was not enough upside movement in the index on a closing basis to reverse the sell. Currently the indicator is working toward a renewed sell signal. 
• Our longer-term VIX Indicator remains on a buy signal. 
• From a short-term perspective, the market sentiment model remains negative. 
• The intermediate-term Sentiment Model is stuck in the red zone. 
• Longer-term Sentiment readings are also solidly negative. 
• It is important to note that when the trend of the market is strong, extreme readings from the early warning board should be present before you think about changing directions.

THE STATE OF THE MACRO PICTURE

Now let’s move on to the market’s “external factors” – the indicators designed to tell us the state of the big-picture market drivers including monetary conditions, the economy, inflation, and valuations.

Executive Summary:

• While it may sound odd with the Fed likely to raise interest rates for a fourth time this week, absolute Monetary conditions remain neutral. 
• Ditto on the Relative Monetary Model… 
• Our Economic Model continues to suggest a strong economic growth environment. 
• The reading of the Inflation Model continues to move lower and is currently at the lowest level seen in nearly 2 years. 
• The song remains the same for the Absolute Valuation Model – this market is overvalued. 
• Our Relative Valuation Model continues to benefit from low rates and suggests stocks are not overvalued when the level of interest rates are taken into account.

SAMPLE RISK EXPOSURE SYSTEM

Below is an EXAMPLE of how some of above indicators might be used in order to determine exposure to market risk. The approach used here is a “Model of Models” comprised of 10 independent Models. Each model included gives separate buy and sell signals, which affects a percentage of the model’s overall exposure to the market.

Trend models control a total 40% of our exposure. The 3 Momentum Models and 3 Environment Models each control 10% of the portfolio’s exposure to market risk. The model’s “Exposure to Market Risk” reading (at the bottom of the Model) acts as an EXAMPLE of a longer-term guide to exposure to market risk.

In looking at the “bottom line” of this model, my take is that readings over 75% are “positive,” readings between 50% and 75% are “moderately positive,” and readings below 50% should be viewed as a warning that all is not right with the indicator world.

The model above is for illustrative and informational purposes only and does not in any way represent any investment recommendation. The model is merely a sample of how indicators can be grouped to create a guide to market exposure based on the inputs from multiple indicators/models.

THOUGHT FOR THE DAY:

There is no education like adversity. -Benjamin Disraeli

CURRENT MARKET DRIVERS

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

    1. The State of Tax Reform

    2. The State of the Economy

    3. The State of Fed Policy

INDICATORS EXPLAINED

Short-Term Trend-and-Breadth Signal Explained: History shows the most reliable market moves tend to occur when the breadth indices are in gear with the major market averages. When the breadth measures diverge, investors should take note that a trend reversal may be at hand. This indicator incorporates NDR’s All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 5-day smoothing and the All-Cap Equal Weighted Equity Series is above its 25-day smoothing, the equity index has gained at a rate of +32.5% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +13.3% per year. And when both are below, the equity index has lost +23.6% per year.

Channel Breakout System Explained: The short-term and intermediate-term Channel Breakout Systems are modified versions of the Donchian Channel indicator. According to Wikipedia, “The Donchian channel is an indicator used in market trading developed by Richard Donchian. It is formed by taking the highest high and the lowest low of the last n periods. The area between the high and the low is the channel for the period chosen.”

Intermediate-Term Trend-and-Breadth Signal Explained: This indicator incorporates NDR’s All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 45-day smoothing and the All-Cap Equal Weighted Equity Series is above its 45-day smoothing, the equity index has gained at a rate of +17.6% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +6.5% per year. And when both are below, the equity index has lost -1.3% per year.

Industry Health Model Explained: Designed to provide a reading on the technical health of the overall market, Big Mo Tape takes the technical temperature of more than 100 industry sectors each week. Looking back to early 1980, when the model is rated as “positive,” the S&P has averaged returns in excess of 23% per year. When the model carries a “neutral” reading, the S&P has returned over 11% per year. But when the model is rated “negative,” stocks fall by more than -13% a year on average.

Cycle Composite Projections: The cycle composite combines the 1-year Seasonal, 4-year Presidential, and 10-year Decennial cycles. The indicator reading shown uses the cycle projection for the upcoming week.

Trading Mode Indicator: This indicator attempts to identify whether the current trading environment is “trending” or “mean reverting.” The indicator takes the composite reading of the Efficiency Ratio, the Average Correlation Coefficient, and Trend Strength models.

Volume Relationship Models: These models review the relationship between “supply” and “demand” volume over the short- and intermediate-term time frames.

Price Thrust Model Explained: This indicator measures the 3-day rate of change of the Value Line Composite relative to the standard deviation of the 30-day average. When the Value Line’s 3-day rate of change have moved above 0.5 standard deviation of the 30-day average ROC, a “thrust” occurs and since 2000, the Value Line Composite has gained ground at a rate of +20.6% per year. When the indicator is below 0.5 standard deviation of the 30-day, the Value Line has lost ground at a rate of -10.0% per year. And when neutral, the Value Line has gained at a rate of +5.9% per year.

Volume Thrust Model Explained: This indicator uses NASDAQ volume data to indicate bullish and bearish conditions for the NASDAQ Composite Index. The indicator plots the ratio of the 10-day total of NASDAQ daily advancing volume (i.e., the total volume traded in stocks which rose in price each day) to the 10-day total of daily declining volume (volume traded in stocks which fell each day). This ratio indicates when advancing stocks are attracting the majority of the volume (readings above 1.0) and when declining stocks are seeing the heaviest trading (readings below 1.0). This indicator thus supports the case that a rising market supported by heavier volume in the advancing issues tends to be the most bullish condition, while a declining market with downside volume dominating confirms bearish conditions. When in a positive mode, the NASDAQ Composite has gained at a rate of +38.3% per year, When neutral, the NASDAQ has gained at a rate of +13.3% per year. And when negative, the NASDAQ has lost at a rate of -8.5% per year.

Breadth Thrust Model Explained: This indicator uses the number of NASDAQ-listed stocks advancing and declining to indicate bullish or bearish breadth conditions for the NASDAQ Composite. The indicator plots the ratio of the 10-day total of the number of stocks rising on the NASDAQ each day to the 10-day total of the number of stocks declining each day. Using 10-day totals smooths the random daily fluctuations and gives indications on an intermediate-term basis. As expected, the NASDAQ Composite performs much better when the 10-day A/D ratio is high (strong breadth) and worse when the indicator is in its lower mode (weak breadth). The most bullish conditions for the NASDAQ when the 10-day A/D indicator is not only high, but has recently posted an extreme high reading and thus indicated a thrust of upside momentum. Bearish conditions are confirmed when the indicator is low and has recently signaled a downside breadth thrust. In positive mode, the NASDAQ has gained at a rate of +22.1% per year since 1981. In a neutral mode, the NASDAQ has gained at a rate of +14.5% per year. And when in a negative mode, the NASDAQ has lost at a rate of -6.4% per year.

Short-Term Overbought/sold Indicator: This indicator is the current reading of the 14,1,3 stochastic oscillator. When the oscillator is above 80 and the %K is above the %D, the indicator gives an overbought reading. Conversely, when the oscillator is below 20 and %K is below its %D, the indicator is oversold.

Intermediate-Term Overbought/sold Indicator: This indicator is a 40-day RSI reading. When above 57.5, the indicator is considered overbought and wnen below 45 it is oversold.

Mean Reversion Model: This is a diffusion model consisting of five indicators that can produce buy and sell signals based on overbought/sold conditions.

VIX Indicator: This indicators looks at the current reading of the VIX relative to standard deviation bands. When the indicator reaches an extreme reading in either direction, it is an indication that a market trend could reverse in the near-term.

Short-Term Sentiment Indicator: This is a model-of-models composed of 18 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from a short-term perspective. Historical analysis indicates that the stock market’s best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.

Intermediate-Term Sentiment Indicator: This is a model-of-models composed of 7 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from a intrmediate-term perspective. Historical analysis indicates that the stock market’s best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.

Long-Term Sentiment Indicator: This is a model-of-models composed of 6 independent sentiment indicators designed to indicate when market sentiment has reached an extreme from a long-term perspective. Historical analysis indicates that the stock market’s best gains come after an environment has become extremely negative from a sentiment standpoint. Conversely, when sentiment becomes extremely positive, market returns have been subpar.

Absolute Monetary Model Explained: The popular cliche, “Don’t fight the Fed” is really a testament to the profound impact that interest rates and Fed policy have on the market. It is a proven fact that monetary conditions are one of the most powerful influences on the direction of stock prices. The Absolute Monetary Model looks at the current level of interest rates relative to historical levels and Fed policy.

Relative Monetary Model Explained: The “relative” monetary model looks at monetary indicators relative to recent levels as well as rates of change and Fed Policy.

Economic Model Explained: During the middle of bull and bear markets, understanding the overall health of the economy and how it impacts the stock market is one of the few truly logical aspects of the stock market. When our Economic model sports a “positive” reading, history (beginning in 1965) shows that stocks enjoy returns in excess of 21% per year. Yet, when the model’s reading falls into the “negative” zone, the S&P has lost nearly -25% per year. However, it is vital to understand that there are times when good economic news is actually bad for stocks and vice versa. Thus, the Economic model can help investors stay in tune with where we are in the overall economic cycle.

Inflation Model Explained: They say that “the tape tells all.” However, one of the best “big picture” indicators of what the market is expected to do next is inflation. Simply put, since 1962, when the model indicates that inflationary pressures are strong, stocks have lost ground. Yet, when inflationary pressures are low, the S&P 500 has gained ground at a rate in excess of 13%. The bottom line is inflation is one of the primary drivers of stock market returns.

Valuation Model Explained: If you want to get analysts really riled up, you need only to begin a discussion of market valuation. While the question of whether stocks are overvalued or undervalued appears to be a simple one, the subject is actually extremely complex. To simplify the subject dramatically, investors must first determine if they should focus on relative valuation (which include the current level of interest rates) or absolute valuation measures (the more traditional readings of Price/Earnings, Price/Dividend, and Price/Book Value). We believe that it is important to recognize that environments change. And as such, the market’s focus and corresponding view of valuations are likely to change as well. Thus, we depend on our Valuation Models to help us keep our eye on the ball.