Tag Archives: income

Financial Stress Index Is Screaming, ‘Bear Market Rally’

What if investors had a way to determine the extent of “stress” in the financial system? And what if those stress levels could tell investors whether or not riskier assets (e.g., stocks, higher-yielding debt, etc.) can succeed without definitive U.S. Federal Reserve intervention? Consider the Cleveland Financial Stress Index (CFSI). The CFSI monitors the well-being of a wide range of financial markets, including credit, equity, foreign exchange, funding, real estate and securitization. According to the Cleveland Fed, a CFSI reading greater than 1.855 represents the highest threat level to the financial system. We’re sitting at 1.91. Click to enlarge Both the Asian Currency Crisis in 1998 and the eurozone Debt Crisis in 2011 wreaked havoc on the typical U.S. stock. Small company shares, mid-sized company shares as well as shares of the average large company declined 20%-30%. On the other hand, when the popular market cap-weighted Dow and S&P 500 barometers approached the 20% bear market line in those crises, the U.S. Federal Reserve promptly stepped in. In 1998, the Fed orchestrated a bailout of the infamous hedge fund, Long-Term Capital Management, and sharply cut interest rates. In 2011, the Fed helped coordinate worldwide central bank stimulus as well as introduced “Operation Twist” — selling short-dated U.S. Treasuries to buy longer-dated U.S. Treasuries for the purpose of depressing borrowing costs. What about 2008? The U.S. Federal Reserve did slash interest rates dramatically in the first quarter. What’s more, the Fed organized the bailout of Bear Stearns in March of that year, sparking a relief rally that kept the S&P 500 well above the bear market demarcation line for three more months. But it wasn’t enough. Even cutting the Fed Funds overnight lending rate to 0% by December wasn’t enough. The Fed wasn’t able to inspire confidence again until quantitative easing (QE) began in 2009. The recent rally for riskier assets here in 2016 is similar to relief rallies in the past; that is, shorter-term gains often overshadow longer-term financial distress as well as deteriorating market internals. For instance, a rising price ratio for iShares 7-10 Year Treasury (NYSEARCA: IEF ):iShares iBoxx High Yield Corporate Bond (NYSEARCA: HYG ) is indicative of a preference for risk-off investment grade credit over speculative higher yielding credit. Is there anything in the present IEF:HYG price ratio to suggest that the longer-term trend is abating? Now step back in time to the 10/2007-3/2009 bear. The IEF:HYG price ratio steadily marched higher until March of 2008. The Fed bailout of beleaguered financial firm Bear Stearns temporarily provided relief for risk assets, but the relief rally ended three months later. Once more, the IEF:HYG price ratio ascended like a mountain climbing enthusiast. History teaches us that the Fed is unlikely to ride to the rescue unless the Dow and the S&P 500 challenge bear market territory. Even then, the rescue endeavor would require sufficient firepower. These historical precedents, then, make the current relief rally particularly troubling. For the Fed to wait until the major benchmarks buckle means that the financial system may grow increasingly unstable. And by then, cutting rates back to the zero bound or twisting shorter-term maturities to purchase longer-dated ones may be insufficient. Again, the Fed’s own assessment tool places the financial system at the highest level of instability, Grade 4 “Significant Stress.” Recall that the iShares All World Ex US Index ETF (NASDAQ: ACWX ) has already depreciated 25%-plus from the top. Small caps in the Russell 2000 (NYSEARCA: IWM )? Ditto. Transportation stocks in the iShares DJ Transportation ETF (NYSEARCA: IYT )? Nearly 30% erosion. Bear market descents have occurred in virtually every stock arena. It follows that when a wide range of stock types are fading, and when a wide range of debt types of different credit quality relative to U.S. treasuries are faltering, popular benchmarks like the Dow and S&P 500 eventually follow suit. The S&P 500 SPDR Trust (NYSEARCA: SPY ) will not be a lone exception. A hold-n-hope advocate may not wish to change any aspect of his/her portfolio holdings, regardless of financial stress levels, historical probability, technical trends or fundamental overvaluation concerns. On the flip side, an investor who wishes to reduce exposure to downside risk can use a bear market rally to his/her advantage . Jettison a lower quality junk bond ETF for a higher quality investment grade corporate bond ETF like iShares Intermediate Credit (NYSEARCA: CIU ). Trade in a lower quality stock ETF for a higher quality stock ETF like iShares MSCI USA Quality Factor (NYSEARCA: QUAL ). And disregard those who boldly declare that “cash is trash.” My moderate growth and income clients have witnessed less volatility and have experienced better risk-adjusted returns with roughly 20%-30% cash/cash equivalents since last summer. (And that’s before the levee broke .) Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

A New Leading Indicator Of Stock Market Direction

Click to enlarge I just discovered a new leading indicator of U.S. stock market direction, and I’d like your thoughts on its efficacy. The following graph shows the history of the indicator going back to 1998. It forecast the market declines in 2000 and 2008, and is currently forecasting another market correction. A high indicator precedes a market sell-off. A low indicator signals a recovery, and a flat indicator is a predictor of average returns. The returns shown in the graph are the average quarterly returns over the year following the indicator date. They’re rolling 4-quarter averages. Click to enlarge The Indicator I created and maintain the Surz Style Pure indexes that break the stock market into large, middle and small, and within each of these sizes into value, core and growth. Morningstar style boxes use a similar approach, and were introduced several years after I launched my indexes. My index definition for large companies is the top 65% of the market. I sort the 6000 companies in the U.S. stock market by capitalization and start adding until I get to 65% of the total capitalization. I’ve recently noted that the breakpoint for large companies has recently reached its highest point ever – $22 billion. A large company, by my definition, is currently above $22 billion. There are currently 227 U.S. companies that meet this rule, with total capitalization of $16 trillion, which is 65% of the $25 trillion total market size. This large company breakpoint is the indicator shown in the graph above. It has successfully predicted the last two market cycles, and is signaling that a major market decline started last year with more to come. This supports my prediction for a 19% loss in 2016 based on pure fundamentals. So why does this breakpoint indicator work, and most importantly will it work this time? Here are some possible explanations: Mega cap market domination is cyclical, and the (capitalization-weighted) market goes where the mega caps go. It’s just another measure of overpricing, big companies becoming too expensive. Investors flee to the safety of big companies when they’re worried, and worry ultimately turns into panic. It’s not a leading indicator at all. The apparent correlations are spurious. What do you think? Have I stumbled onto something? What is it telling us about 2016? Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Making The Patient Sicker

By Craig Lazzara Years ago, I saw a cartoon picturing two Victorian-era doctors discussing a patient. “What did you prescribe for Jones’ rheumatism?” asked the first; the second answered “A cold bath and a brisk walk every morning.” “Good God, man, that will give him pneumonia!” said the first. “I know,” replied the second doctor, “I made my reputation curing that.” Somehow I was reminded of this exchange when I learned from this morning’s news that some institutional investors, smarting from recent losses, are considering increasing their commitment to active equity management. Their operating assumption seems to be that active managers will do a better job of capital preservation in a challenging and volatile market. There’s certainly some plausibility to this argument. It turns out, however, to be another beautiful theory mugged by a gang of facts . The facts come from our periodic SPIVA reports, which compare the results of actively-managed mutual funds against passive benchmarks. Weak markets, it turns out, are no panacea for active managers. In 2008, e.g., 54% of large-cap U.S. funds underperformed the S&P 500. Results were even worse for mid- and small-cap managers (75% and 84% underperformers, respectively). Statistics say, in other words, that moving from passive to active as a way of managing market volatility is likely to make performance worse, not better . Fortunately for anxious investors, passive strategies which focus on the lowest volatility segment of the equity market are most likely to outperform precisely when the market is weakest. Consider, for example, the S&P 500 Low Volatility Index and its cousin, the S&P 500 Low Volatility High Dividend Index: Both of these indices are designed to attenuate the returns of the S&P 500 in both directions; historically, they have both tended to underperform market rallies but outperform when markets are weak. Their reliability as defensive vehicles has far exceeded that of active management. Investors concerned about continuing volatility and market weakness should consider indicizing their defensive strategies. Disclosure: © S&P Dow Jones Indices LLC 2015. Indexology® is a trademark of S&P Dow Jones Indices LLC (SPDJI). S&P® is a trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a trademark of Dow Jones Trademark Holdings LLC, and those marks have been licensed to S&P DJI. This material is reproduced with the prior written consent of S&P DJI. For more information on S&P DJI and to see our full disclaimer, visit www.spdji.com/terms-of-use .