Thursday, November 1, 2018

November 2018 Market Update - Choppy Waters

The S&P 500 lost 6.96% in October, ending the month at 2,711.74. YTD the S&P 500 is now up 1.43%. I'll keep our intro brief today, so we can spend more time reviewing price, sentiment and valuation as we start November.

Price
Source: dshort blog, Moving Averages: October Month-End Update

Price action has not looked this negative in well over a year and probably caught many investors off guard. According to the Ivy Portfolio system four of the five asset classes as represented by Vanguard Total Stock Market ETF (VTI), Vanguard FTSE All World ETF (VEU), iShares Barclays 7-10 Year Treasury (IEF), and PowerShares DB Commodity Index (DBC) — signal being in "cash" rather than "invested" as we start November. Vanguard REIT ETF (VNQ) is the only asset class ending the month "invested." Variance shows VNQ barely stayed invested at the end of October. At the end of November we'll know if any of these positions whipsaw us in and out of the market. Outside of the price action for these five asset classes, the dollar appreciated again in October. After declining in 2017, the dollar, as represented by Invesco DB US Dollar Index Bullish Fund (UUP), has rallied 7.45% YTD through the end of October. Emerging markets, as represented by the iShares MSCI Emerging Markets ETF (EEM), lost 8.76% during the month of October. Remember VEU (Vanguard FTSE All-World ex-US Index Fund ETF) signaled "cash" rather than "invested" at the end of May 2018, so if you followed that signal you missed the additional losses of foreign markets, including emerging markets, during October.

Sentiment
Source: CNN Business Fear & Greed Index

Sentiment moved from "Neutral" to "Extreme Fear" during the month of October. At the beginning of October two indicators read "Extreme Fear." Those were: 1) CBOE 5-Day Average Put/Call Ratio and 2) Net new 52-week highs and lows on NYSE. One indicator, the Yield Spread: Junk bonds vs. Investment Grade, started October reading "Extreme Greed" and ended the month at "Fear." As we start November sentiment is currently reading "Extreme Fear" with no components of the index reading "Greed" or "Extreme Greed." Only one component, Market Volatility, ended October at "Neutral." Five of the remaining six criteria all measure "Extreme Fear" with only Yield Spread reading "Fear." I'm interested to see if this index can bounce out of "Extreme Fear" during November.

 Valuation
Let's start with examining the price to sales ratio for the S&P 500. The information below is from the site multpl.com. If you visit the link you'll see the chart of this data from 2001 to present.
The minimum value for the P/S ratio since 2001 occurred in March of 2008 coinciding with the market low when it reached 0.80. The maximum value for the P/S ratio happened in September of 2018, the month of our current market top. This overvalued market remains vulnerable to a continued decline with the current P/S ratio reading 2.10. To further illustrate how overvalued the market is in 2018, let's review the following chart showing the Wilshire 5000 Total Market Cap Full Cap Index/Gross Domestic Product from 01/01/1971-07/01/2018:
Please click on the chart to enlarge
Source: U.S. Bureau of Economic Analysis, Wilshire Associates, fred.stlouisfed.org

I highlight this chart because it shows how the market correction in February and March 2018 barely made a dent in this ratio. There's simply a lot of room for this ratio to drop before it reaches a value close to the bottoms of the last two recessions.

If you like studying valuation, I suggest you examine two additional sources:
Summary
Market declines unsettle investors. Sentiment levels measured by the CNN Fear & Greed Index quickly shifted from "Neutral" at the start of the month to "Extreme Fear" for the majority of October.  When US stocks declined in February and March of this year the S&P 500 remained invested and did not trigger a sell signal based on the Ivy Portfolio system. As we examine this month's closing value for the S&P 500, it's below the 10-month simple moving average signaling investors should end the month in "cash" not "invested" according this system. The following chart shows how long it has been since we've experienced this condition in the U.S. market:
Please click on the chart to enlarge
Source: dshort blog at Advisor Perspectives

The last time we transitioned from an uptrend to choppy waters in the U.S. market was during the fall of 2015 through March 2016. This period included a "hurricane warning" when the 5-month simple moving average fell below the 12-month moving average for the S&P 500. This month's signal to cash occurred at more extreme valuation levels which increases the probability of a more significant decline ahead. We'll continue to listen to the market and review the data as we progress through Q4 into 2019. The chorus of people saying the probability of recession in 2020 is so loud I need to mention it and provide you with some links to read more:
Frankly, I care more about what is happening right now than what will or might happen in 2020, however when so many economists share the same sentiment it deserves mentioning. We know the market frequently anticipates any slowdown. Before we leave let's review the five most important questions for investors plus my bonus question:
  1. How much cash do you need to feel secure with your finances? 
  2. Do you have a written investment plan? 
  3. How does each investment enhance your portfolio? 
  4. Are you adequately insured against catastrophic risks? (i.e. auto, house, life, disability, long term care, longevity, health insurance, etc.) 
  5. Have you created and implemented your estate plan? Is it updated? 
A bonus question: Do you have an evaluation framework for your portfolio? (i.e. Are you aware of the costs of your investments? the diversification of your investments? the risk/volatility of your portfolio? the tax impact of your investments? and do you have a method for tracking your performance?) Let's end with this quote from Charles D. Ellis:
"The principal reason we should all articulate our long-term investment policies explicitly and in writing is to protect our portfolios from ourselves." 
As always, wise investing my friends.
Please consult a qualified financial advisor before making any investment decisions. This blog is for educational purposes only and does NOT constitute individual investment advice.
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Here's what I've been reading, listening to and watching recently:
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