Things That Lead – Early Optimism: Signs of Bottoms, Lows, and Pivots | Stock Talk
In late October of last year in the first few of our first YouTube videos within Oak Harvests investment series, I covered 4 of the real time data series that we follow that were early warning signs of rallies and then followed it up with a video on 2 data series that are early warning signs of market tops and corrections. Here’s the link to that content it if you are interested. https://www.youtube.com/watch?v=u1rc5FwNb8k
I am Chris Perras, Chief Investment Officer at Oak Harvest Financial Group. The markets are in correction territory. We did forecast this back in 4th quarter of 2021 saying we expected a -10-12% correction in the first quarter of 2022. Recall viewers definitionally a correction is defined as -10+ in the SP500. Well, if you were perfect at selling the cash closing high and buying everything back at the cash closing low on February 23rd you avoided -11.85%. Is this fun? No, not one bit. It would be particularly bad if you were leveraged. Something we do not do at Oak Harvest.
However, now many on TV are calling out many of the early warning indicators as bearish. Things like the flattening yield curve and the higher bond volatility, move index which supports collateral and leverage we spoke of back in 4q2021 are now becoming commonplace on TV.
Given we are in our third or possibly fourth month of this downturn, if you count late November as the top given when divergences began, I wanted to update our viewers on where a few indicators now stand. Why? Because there are a few that are beginning to turn try to inflect positively. Call this episode, early optimism signs.
Despite still being in a very messy time period that our team has been foreshadowing for months, and which we expect to continue for months, I want to bring a little optimism to what might be many equity investors, otherwise gloomy outlook.
Three data series that have historically led bottoms, lows, and pivots up during corrections we will be covering are, 1-investor sentiment, 2- forward volatility pricing, and 3) market breadth.
Viewers, make no mistake, this is not a dip, neither in price, percent decline or length of time. So, far, this is a good old fashion gut-check of a correction in the SP500.
And unlike the fast and swift 3-5% dips we experienced from during the 2nd half of 2020 through the end of 2021, corrections 1- take longer to rectify themselves, 2- go deeper than run of the mill dips, and 3-are best confronted more slowly due to extended periods of high realized volatility. Corrective markets, like the one we currently appear to be in, take months and quarters to play out not days and weeks. They are best approached with a slower dollar cost averaging pace, rather than a prey and pounce type trading behavior during a quick dip environment.
Viewers, against the backdrop of a horrible, unprovoked attack on Ukraine by Russia it appears that some very early leading signs are in the process of troughing and turning toward more positive readings.
The first early bullish sign is a contrarian signal we have discussed in the past, individual investor market investment sentiment. From a contrarian point of view, negative extremes in investor sentiment, during corrective periods within bull markets is bullish. The AAII, that’s the American Association of Individual Investors, dropped below 20% for the first time in 6 years. Here is the table of forward stock returns, provided by Merrill Lynch, over the last 35 years. There were 13 such occasions, and ex January 2008 each 12- and 18-months return was very high. Even including the great financial crisis, negative -35%+ return, the average 12-month forward return was? Over 15%%. Other investor sentiment measures have similar data with returns of 17.5-20% common once sentiment flips positive from low levels such as these.
Here’s another sentiment chart provided by Ned Davis research, like the Larry Williams indicator I discussed last week. It’s a global stock versus bonds valuation ratio and it has quickly fallen to levels that signaled the last two great “buy and molds” over the last 24 months. Those being April 2020 during the Covid shutdowns, and October 2020 in front of the 2020 Presidential election.
The second data set I wanted to flag is the recent uptick in improving market breadth. Yes, you heard that right, market breadth is getting better not worse. On Wednesday March 2nd, the SP500 had a 11 to one upside day. This means that 11 stocks in the SP500 were positive on the day for every one that was red. According to research from Strategas, 15% of the SP500 had a positive 2 standard deviation move to the upside last Wednesday and while that was below Friday February 25ths 26% showing, it is still very high and indicates that behind the scenes buyers are showing up in mass on weakness. Yes, the excuse you hear on TV is “its just short covering”, is probably true. However, sustained up moves have to start someplace and given positioning and the amount of put buying done on the way down in January and February, short covering is the way the first wave up in almost all bottoms start. The key to this indicator is looking for a second and higher “breadth thrust” day in the upcoming weeks. These types of days have historically confirmed that the sellers have exhausted themselves, and the longer-term equity buyers have returned in mass. Historically, a lot of these days will come on a bad Friday and positive Monday. Why? You get a lot of Friday margin call selling taking place followed by more early morning Monday selling after the weekend. However, The wave of forced selling exhausts itself early, and then long term buyers swoop in with liquidity and buy orders, reversing the markets higher. If you want a classic example of this pattern, the best recent example, was the Covid Friday March 20th and Monday March 23rd lows and Tuesday 24th reversal up. A similar but more subtle pattern emerged on Friday Oct 30th and Monday November 2nd in front of the 2020 Presidential election.
The third and final indicator that provides a little earlier hope for more of a rally off our January lows during the coming 2nd quarter? Forward volatility market pricing. These forward pricing markets were one of the key early warning indicators our team sleuthed on back in 4th quarter 2021 to forecast the current correction and timing. While this indicator is much more opaque now then they were back then, probably because of ongoing Russians aggressions, they are saying that a lot of negative sentiment and downward price moves in % terms are already priced in to the SP500. These forward markets continue to trade at level around 28, and almost uniformly, when they get higher than this for a few days, insurance salesmen come in and sell forward insurance. This dynamic should be considered bullish for future time periods. In laymen’s terms, it means that these insurance salesmen are still happy selling their insurance products out beyond three months at these levels. Even with Covid, even with Federal reserve uncertainty, and even with Russia invading Ukraine. As they have for 4 months, their look into the future beyond 1st quarter of 2022, says they believe “this too shall pass” in the overall markets in the coming months.
If you want some data, a recent piece of research done by JPM gives us some historical reference around this topic of volatility. According to JPM, a buy signal in the SP500 has been triggered when the spot CBOE Vix index rises by more than 50% above its 1 month average. This happened on January 25th according to their firm. Over the last 30 years, outside of recessions, this indicator has given a perfect buy signal 21x since 1990, with the average gain being +9% over the following 2 quarters. As we know, past performance is no guarantee, and no indictor is perfect.
So there you go, 3 indicators that are starting to lean positive for equities for the upcoming months. Are these perfect? No. Are they precise and easy to read as they were in 2020 post Covid or pre-2020 Presidential election? No. There’s a lot of messy conflicting things going on, many which we had expected and a big current one in the Russian invasion of Ukraine which we did not. However, these three data series, sentiment, breadth, and future volatility are starting to say, while the next few quarters of 2022 won’t likely be all rainbows and butterflies and ice-cream, the clouds should start to clear in the not so distant future.
At Oak Harvest, we think our clients are best served by us helping them with their future needs and risks, instead of dwelling on the past. Our crystal ball is far from perfect, but we like to keep you up on what it’s saying about the uncertain future, not about what we already know about a certain past.
Oak Harvest is a comprehensive financial planning adviser located in Houston Texas. Give us a call to speak to an advisor and let us help you craft a financial plan that meets your retirement goals. Call us at (877) 896-0040, we are here to help you on your financial journey into and through your retirement years.
I’m Chris Perras and have a great weekend!
CFA®, CLU®, ChFC®
Chief Investment Officer, Financial Advisor
Chris is a seasoned investment professional with over 25 years of experience working with some of the most successful money management firms in the world. Chris has made it a point in his career to adapt as the market landscape changes, seeking to utilize the appropriate investment strategy for a given market environment. His transition from managing billions of dollars at the institutional level to helping individuals and families retire is guided by a desire to see first-hand the impact he is making in the lives of clients at Oak Harvest.