2017 | September Risk Odometer

Our Risk Odometer continues to remain fully into bullish territory, giving our equity strategies a full equity allocation.  The main drivers (Economic Indicators, Earnings, Technical Price Action) continue to remain in a firm, positive trend.  The components inside of these indicators are also displaying widespread positive contributions, adding to the positive trend.  Elevated valuations and a bull market which has lasted well beyond historical averages continue to remain as risks.  Despite these concerns, we continue to remain positive on risk assets given our more timely indicators.

September 2017 Monthly Review

• Risk Odometer falls to +5 but still well into bullish territory.
• September was a reversal month for this year’s laggards.
• Economic data released in September continues its positive trend

Given September was a quarter end, I felt it would be an appropriate time to do a bigger picture review.  Overall, the equity markets have experienced a remarkable run following the presidential elections in November 2016.  The S&P 500 is up almost 21% over that time and has seen positive returns every month, a very remarkable feat!  Many are worried about sky high valuations, myself included.  I believe these concerns are justified but I also understand that valuations tend to be a terrible timing tool.  For myself, I try to divorce myself from the emotions of the markets and focus on objective, historically relevant data to guide my decisions.  This is where my Risk Odometer comes into play.  The Risk Odometer does not include valuation metrics in it because I have not found them to be great timing tools.  Valuation is better at identifying when markets may be vulnerable, but they do not do a very good job of identifying when.  The data the Odometer uses has shown to do a better job of this.

So, what is the Risk Odometer telling me now?  It is telling me to stay involved in this rally.  It can quickly change quickly but it has yet to pick up enough warning signs to warrant a defensive posture.  It did drop one notch to +5 at the end of September, but it is still firmly in bullish territory.  Leading economic indicators continue to post healthy gains, earnings have been solid and technical price action has also been very positive.  The small decline in the net score came from the Sentiment category turning neutral, but not a concern for the big picture.  

I have gotten some questions about what lies under the hood of the Risk Odometer so I thought I would do my best to address this.  For simplicity and understanding, I thought I would focus on three indicators, Economic Indicators, Earnings and Technical Price Action.  I call them The Big Three.  I chose them because, alone, they give a clear pulse of the current landscape.  My testing has also shown that nearly 90% of the benefit of using all 7 categories can be captured by these 3 alone.  Currently the Big Three are in unison, all pointing towards bullish conditions.  Below, I will describe them further.

Big Three #1:  Leading Economic Indicators

The first indicator of The Big Three is Leading Economic Indicators, a basket of leading indicators put forth by the Conference Board.  The chart below is my preferred method of analyzing it.  In the spirit of “keeping it simple”, I simply identify if the year-over-year rate of change is positive or negative.  From the chart below, positive rates of changes (bullish conditions) occur when the blue line is above the red horizontal line.  Currently, it is flashing a bullish signal and has been all year.  It has actually given bullish signals since 2009 and remaining bullish for the entire bull cycle that began earlier that year.  It turned lower in 2010 and 2015 but never displayed negative rates of returns.  It currently stands near 5% and has been trending even stronger since it turned up in 2016.  

In addition to the positive rates of change, I also like to analyze the breadth of positive contributors, or how wide spread they are.  If only a few of the 10 indicators are driving the growth, it is less likely to continue to grow, but if the growth is widespread among the 10 different indicators, then it is more likely to continue to grow.  Currently 80% of the indicators are positive, a sign of continued growth.  

Other means of cross checking the Leading Economic Indicators is monitoring other institutions version of similar leading indicators.  Goldman Sachs and the Economic Cycle Research Institute maintain similar indices.  There indices are also showing positive rates of changes, thus confirming the leading indicators from the Conference Board.

Big Three #2:  Earnings

The second indicator of The Big Three are Earnings.  Again, in the spirit of “keeping it simple” and seeking to identify the trend of the earnings landscape, I will look at year-over-year rates of changes in total earnings for the S&P 500.  The chart below is a graph of that rate of change.  Values above the red line are positive rates of change and generate bullish signals.  Earnings turned negative in 2014 and 2015 but recovered in 2016 and have been generating bullish signals for the past all year.  The breadth of positive earnings contributions also depicts further growth ahead as all 10 sectors in the S&P 500 are all contributing positively.  If any level of tax reform gets passed, it would likely contribute to continued year-over-year earnings growth, since many of the tax reforms should benefit small and large companies.

Big Three #3:  Technical Price Action

The third indictor of The Big Three is Technical Price Action.  To measure this, we identify the level of the S&P 500 relative to the 50 and 200 day moving average of the index.  When the level of the S&P 500 is above these moving averages, the market is displaying positive momentum.  Because the market is often driven by sentiment, momentum has always played a factor in driving asset returns.  When this momentum is positive, we get bullish signals, and when it is negative, we get negative signals.  This signal can be seen in the chart below.  The black line is the S&P 500, the green line is the 50-day moving average and the red line is the 200-day moving average. Currently, the S&P is well above its 50 and 200-day moving averages and the 50-day moving average is also well above the 200-day moving average, another healthy momentum sign.  

In summary, our timely indicators continue to display a positive landscape for the stock market.  Five of the 7 indicators are positive and The Big Three are also all positive.  My main concern continues to lie with valuations.  Current valuations are at historically excessive levels.  Valuation, though, has never been a great timing tool.  What it does create is a sense of vulnerability for the market when risk factors do emerge.  The market does not go in one direction and drawdowns in excess in of 20% occur about once in every 3.5 years.  We have not experienced one in nearly 9 years.  It will eventually occur but projecting when is nearly impossible.  What is more important, though, is to have a plan in place before it occurs.  We believe that plan should include monitoring current conditions and being prepared to adapt your portfolio in order to protect your capital.

Disclosures

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