A New Beginning?

I posted a few months ago about the breakout in gold. It was so obvious it made me wonder whether it was going to turn out to be a fake out. I had my doubts. At the time, it was a textbook technical setup for a trade not a long-term buy and hold position. Since then, from a purely price perspective, it has done everything an investor could hope (up ~10% in less than 3 months), pausing where it should have and looks like it is ready to complete the initial breakout pattern as it is making a push to its upside target. In spite of all these positives and because we want to only be over-weighted investments that are outperforming the benchmark, there was no reason to be over allocated because it has been under-performing the US stock market (SP500 index) … that is until just recently.

Ya gotta love ratio charts as they easily let you compare investment performance and thereby providing a path to improve performance. Remember, when looking at a ratio of gold to the SP500, if the ratio is falling, gold is under-performing and when the ratio is rising, gold is outperforming. Taking a look at the ratio of gold to SP500 chart below, you can see gold has been severely under-performing US stocks for 7 years. In fact, the SP500 has outperformed gold by more than 70% over that time period. For gold investors, those were 7 lost years. What is very interesting is the chart is now telling us that probability of future under-performance from holding gold may have ended. Notice how the ratio has broken the long-term (red) downtrend line? Just breaking the trend line is only a start. To confirm, after the break you want to see a new uptrend beginning as defined by higher highs and higher lows.  I have illustrated the chart to make its recent confirmation clearer … #1 marks the first higher high, #2 the first higher low and #3 the second higher high. If, (this is a big if) the ratio goes on to make another higher low, we can say with high confidence that the secular under-performance of gold in relation to US stocks has ended.

Why this is such a big deal is because gold has historically been an investment that trends and trends for long periods of time (years). If this is in fact the start of a new secular trend, it’s an ideal time for investors to begin rotating money out of US equities and into the precious metals complex.

Weak Week

As Rob Hanna posted at Quantifiable Edges, this week has historically been the worst week of the year for US stock performance. Since 1960 the week following the 3rd Friday in September has produced the most bearish results. The chart below shows how this week has played out over the past 59 years.

As you can see there was a stretch back in the 80’s with a series of mild up years but overall, and especially since 1990 its been pretty much all downhill. The table below shows the result of buying the SP500 on the 3rd Friday of September (options expiration) and selling it x-days later (x days = 1-5 reflecting the entire week)

On of the past 28 years, only two, 2001 and 2017, posted a gain. 2001, of course, provided an uncommon backdrop and 2017, saw the index rise a whopping 2 points.

Unless you are a short-term trader this information does not provide an investment edge. For those with longer time frames, this data should be viewed as nothing more than setting an expectation for what may be a disappointing week for those invested in US stocks.

Loyal Dissenter

I love to play the 10th man. It gets me in trouble a lot though. It comes across as argumentative or combative if you forget about the key word in the job, “loyal”. As humans one of our biggest flaws when it comes to making the best decisions is our default response to anchor only on our beliefs or the consensus. Of course, the best decisions are those that are made by looking at every solution, including those that present the other side of our beliefs.  If we remember the goal is to make the best decision and not about our ego and being right, we stand a much better chance, over the long run, of being better off. This is especially important when it comes to investment/financial decisions and money is on the line.

With that in mind, the “end of the worlders” are out in force. They make a case for this being the end of this economic expansion (the longest in history), bringing in politics, war, negative rates, fake meat etc, etc. and therefore why investors should be de-risking portfolios. Playing the 10th man here and presenting the other side, while it’s not my analysis, the historical technical study done by Tom Bowley below presents a very strong case and why it may be too early to write off bulls just yet. If you are a doom and gloomer, I just ask you keep an open mind and read …

 “I've been adamant that we remain in a secular bull market, and I'm sticking to it. Yes, September scares me. The Fed petrifies me. And no more tweets, please! Oh, and let's not forget about the inverted yield curve (which isn't inverted any longer, by the way). But, despite all of that, here we sit on the brink of yet another record all-time high on the Dow Jones, S&P 500 and NASDAQ. It's going to happen.

Over the past week, we saw new leadership emerge. Financials (XLF) did very well, as did industrials (XLI). It's easy to forget, but these two sectors were our leaders from 2016 through early 2018, when we raced to new record highs with only the slightest hint of volatility. The small-cap Russell 2000's ETF (IWM) is comprised nearly one-third of financials and industrials. These two sectors are very important to the performance of this closely-watched small-cap index/ETF.

One thing we need to keep in mind is that when transports ($TRAN) and small caps ($RUT) perform well, it generally translates into huge S&P 500 gains. Let's use the 10+ years of this bull market to illustrate:

I think this chart is very clear. When the downtrends and/or consolidation periods in both transports and small caps break to the upside, the S&P 500 is likely poised for a major, explosive rally. While we might be premature, an argument could certainly be made that both the TRAN and the RUT broke their downtrends this week. The next few weeks will likely either refute or confirm that statement, but, if it's the latter, prepare for a launch higher in Q4.”

Epic Shift or Normal Rotation?

If you weren’t looking, you wouldn’t know last week was a disaster for a part of the market that has been a leader for years. Momentum stocks got absolutely pummeled at a time when the overall market was rising. It wasn’t the Nasdaq, which most think of when momentum is mentions, but just the Nasdaq leaders that were creamed. Some lost as much as 20% in 4 days. The momentum ETF basket lost a much more tolerable under 2% while the broader market, SP500, climbed more than 1%.

What is just even more interesting is where that money shifted into. If you have been in the game long enough it shouldn’t surprise you the benefactors were the past laggards, value and small caps. As you can see in the chart below, from left to right, is last week’s return on the SP500 (light blue), followed by momentum (magenta), small caps (green), value (blue) and the Nasdaq (red). It may not seem like much but a difference between the winners and losers of more than 6% in just one week is huge and should not be ignored.

Rotation is normal and how the market continues to ramp higher over time so it could be I am making a mountain out of a mole hill here. On the other hand, if this is the start of a new trend, investors would want to know this because what has worked for the past 3-5 years may no longer. The market is sending a message here and it’s up to us to figure out just what it means.

Value is Dead, Long Live Value

There have been many investment strategies written around value investing and how it has outperformed growth. The debate that rages on between the two camps is fun to listen to because they both have strong cases and are right. How they both can be right is because depending upon the time frame the answer change. As with all things investing, identifying your time frame is the most important thing to know.

The reason for bringing up the topic was as I looked at the past 12-month performance its clear to see value (gold) has substantially under-performed (~20% less) growth. As you can see the under-performance really took hold after the market bottomed last December from its 20% decline. The months prior to that were pretty even. Does this mean you should be ignoring value stocks? Au contraire, divergences such as this can present very compelling investment opportunities. The operative word is can.

From a strength standpoint, as of right now, there is no reason to be buying value …. Just yet. But, when these situations arise, I would (and am) actively looking for a reversal in this divergence. Finding a bottoming pattern on a ratio chart of the two investments is the best way I know of identifying a way to capitalize on this divergence and a potential reversion to mean value run.