Nothing Good Rhymes with August

For regular readers of this blog the name Tom McClellan requires no introduction as I am a big fan of his technical work and repost it regularly. With the dog days of summer upon us and the market a jumbled mess awaiting an impetus, I thought I would use Tom’s most recent work to add a little spice. Today’s post is a look at the seasonality patterns in play and their historical impact.

Everyone knows about annual seasonality, and has heard of “Sell in May and go away”.  That slogan persists even though actual seasonal strength typically peaks in August, but nothing good rhymes with August.  There is also a strong tendency of the market to show regular patterns on a 10-year basis, now known as the Decennial Pattern.  And years ending in the number 7 have an ugly surprise for the bulls. 

In year 7s, the stock market typically peaks in August and bottoms in early November.  And thus far the DJIA seems to be following the pattern very closely.  The real decline comes after a peak due Oct. 3.

The worry in following this pattern is that it might be overly influenced by the huge decline that the DJIA experienced in 1987.  So in the chart above, I show two versions of the Decennial Pattern, the lower one leaving out the data from the entire decade of the 1980s.  This allows us to see that it was not just the effects of the 1987 crash that are pulling down the Pattern in year 7s.  It is a persistent effect. 

The strong correlation that we are seeing this year between the DJIA and the Decennial Pattern is pretty impressive, and it is worth noting that the DJIA had not been seeing such a strong correlation earlier in this decade.  Here is a longer term comparison:

The market strength which is a normal feature of years ending in 5 did not appear this time.  I would argue that having the Fed doing $85 billion a month of QE earlier in the decade pulled forward the normal year 5 strength.  Then shutting off that free money pushed the market into withdrawal symptoms, like a heroin addict trying to quit cold turkey.  Now that we are farther along into the post-intervention era, the market is more free to follow its normal tendencies and we are seeing better correlation to the Decennial Pattern. 

If the stock market keeps following the Decennial Pattern with the strong correlation we are seeing now, then we can expect prices to bump along gradually lower, and then accelerate downward once October gets here. 

The following chart was added by me (Chuck) to provide a look at the DJIA performance for each and every year ending in “7”. The months of August through November have been outlined by the red dashed box. Note, only 1927 was the only year in which November ended higher than August. Will 2017 be the second?

My Precious

Palladium, Pd46, is a rare and luxurious silvery white metal. Without wanting to start the next world war by bringing up this topic (I will leave starting WWIII to Washington, DC), there are some that view palladium as a precious metal right along with gold, silver and platinum.  While palladium was never historically used as coinage (and therefore the argument as to why it is not a “precious” metal), it, like the 3 other precious generals, has been assigned an ISO 4217 currency code. So, that’s precious enough for me.

In the combination 9-year chart above, the price of palladium is represented by the candlestick bars while gold, silver and platinum are the colored (and labeled) lines. As you can see palladium is breaking out to chart highs while gold, silver and platinum are mired in investment purgatory. Interestingly, palladium has been priced higher only once before occurring in 2001 when traders went into a speculative frenzy pushing its price to almost $1100/oz, about $150 from where it closed yesterday.

I wish I knew why the divergence was occurring. Some will say it’s because palladium is an industrial metal and should be increasing as the economy grows. The good thing is in technical analysis we don’t worry about the “why’s” but rather focus solely on price.  With new highs on the radar (it has not been confirmed yet because this is a monthly chart and August is not over), once confirmed signals higher prices ahead with the next target being the 2001 highs

The Rear View Mirror

You can’t do the same things others do and expect to outperform. – Howard Marks

When trying to get a reading on the overall stock market health most everyone uses the SP500 index as their proxy. The problem with doing that is twofold; 1) it includes only 500 stocks. While it is a much better proxy than the Dow Jones Industrials (30 stocks), it is a far cry from including all stocks in our markets which is currently in the neighborhood of 4500. 2) the SP500 index is cap weighted which makes the smaller companies less important. Ideally any index used should include as many in the universe of listed stocks as possible and be equal weighted.

The Value Line Geometric Composite Index (XVG), originally created in in 1961, includes more than 1700 stocks which are equally weighted using a geometric average. Because it is based on a geometric average the daily change is closest to the median stock price change. Suffice to say that while still not perfect it does a much better job of representing the US stock market than almost any other proxy.

With my long term model still very bullish and my short term model flashing a sell signal, these conflicting signals tell me it’s a good time to check in on "the market" (using a daily and weekly chart of XVG) and see what it is telling us. There is nothing more bearish than a failed breakout and is exactly what occurred and we see on the daily chart below. Note how the failed breakout occurred while RSI momentum was creating negative divergence. Since then price breached the 200-day moving average to the downside and closed Friday just below horizontal support (breakdown). The saying is from false breaks come big moves so that failed breakout was a potentially ominous signal and one that got my attention. As you know, horizontal support lines are drawn with fat crayons as they are not one specific price, rather they represent a range or zone. So, Friday’s close may be nothing more than being within that zone and not an actual breakdown. That is why confirmation is always needed when a breakouts or breakdowns occur. Suffice it so say, next week’s price action will be very critical. A confirmed breakdown, points lower with the first two targets are marked with the green horizontal bars, T1 and T2.

Taking a look at a longer weekly look, XVG broke its 2016 bottom uptrend line two weeks back while forming negative RSI momentum divergence. Looking left, notice what happened the last time this occurred from the 2012 bottom uptrend line, price fell 27%.

Since the 2011 failed top, investors have become conditioned to just buy the flipping dip (BTFD) as pullback buyers have been rewarded each time it has occurred. If we get follow through to the downside in the coming week(s), if recent history is our guide, it will likely just be a minor blip on the road higher. But because all bull markets eventually come to an end, investors should never become complacent as every dip may be the start of something much bigger. Either way, the answer will only be known in the rear view mirror.

More Fundies

I get a lot of questions regarding my posts on investment fundamentals. I think the consensus believes I don’t care about fundamental data. The fact is that can’t be further from the truth. My problem with fundamentals and why I don’t use them solely is that they do not provide buy or sell signals. In my process, technical information must first trigger a signal and then be confirmed by fundamental data.  For example if a stock is breaking out of a bullish pattern, if the fundamentals don’t confirm the breakout, there is little need to commit investment capital since without it, the probability of a long-term successful investment decreases. In the short term (such as when day trading, scalping or short term swing trading), all bets are off and fundamental confirmation is worthless.

For the record, I do watch fundamental data which is why I am posting this next chart.

As you can see we have now reached the second highest level of the price-to-sales ratio of the SP500 stock index over the past 25 years.  The only time in which the ratio was higher was at the end of the internet bubble in 2000. Notice how that prior peak in the ratio took 2 years to eventually resolve to the downside. The fact is in today’s market, on virtually every (fundamental and technical) metric I watch, not just the price-to-sales ratio, the US stock market is way over-stretched. But until technicals (price data) provides a sell signal, we need to not fight the trend and accept the fact the markets can continue get even more stretched. At tops and bottoms fundamentals mean little, emotions and feelings drive the markets, not common sense.

Are Fundamentals Supportive of Current US Stock Levels?

“Signs of enhanced momentum in the global economy have recently emerged. Global GDP growth has picked up to an annualized rate of over 3¼ percent since the middle of 2016, with a rebound in industrial production, global trade and investment.” – OECD Global Economic Outlook (June 7)

With more than 90% of the companies in the SP500 having reported results for Q2 here are the results:

Earnings -  Q2 the blended earnings growth rate for the S&P 500 was 10.2%. For companies that generate more than 50% of sales inside the U.S., the blended earnings growth rate is 8.5%. For companies that generate less than 50% of sales inside the U.S., the blended earnings growth rate is 14.0%.

Revenue - The blended sales growth rate for the S&P 500 2017 is 5.1%. For companies that generate more than 50% of sales inside the U.S., the blended sales growth rate is 4.7%. For companies that generate less than 50% of sales inside the U.S., the blended sales growth rate is 6.0%.

What drove the out-performance of S&P 500 companies with higher global revenue exposure? At the sector level, the Information Technology and Energy sectors were the largest contributors to earnings and revenue growth in Q2 for companies with less than 50% of sales inside the U.S.