It’s been a very bullish year, and yet major averages continue to attack their high-water marks time and time again. For many, this instills a sense of unease … a feeling that things are too good right now, and won’t last.
If you find yourself in this camp, take solace in the fact that ultimately you will be correct, it just might take longer than you expect. After all, people have been making this case for a number of years, and anyone who acted on that advice has missed out on a tremendous surge in asset prices.
Eventually, this long-term uptrend will come to an end, but based on recent economic data and price action, that time is not at hand. Let’s walk through some indications that this is the case. (Note: two weeks ago I walked through the economic data supporting this outlook, so today we’ll focus mostly on price action.)
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First up is the MSCI All Country World Index (ex-US) ETF – ACWI. One of the most important things to understand about this current bull market is that it is international in scope. This is not a US story, it’s a global one - so regardless of what happens here (i.e. tax reform passing etc.) the global economic backdrop remains healthy and positive.
In the chart below, we can see that the worldwide bullish trend remains very much intact, with repeated higher highs and higher lows. So far, this telltale bullish pattern has not been broken, but if we want to nitpick, we could make the case that upward momentum is slowing.
Notice that the slope of ACWX has been flattening and that successive higher highs and higher lows have been decreasing in magnitude. This is by no means alarming, as it simply suggests that we may be entering a period of consolidation after a massive run.
While we’re on that topic, I should point out that while the probability of an economic recession or bear market is low, we should be on the lookout for short-term weakness. You could call it a pullback, a consolidation, a correction … whatever you want, but asset prices rarely move as far as they have in one direction without some type of retracement.
There are no guarantees that this will happen anytime soon, but if it does, this action (assuming it's not caused by some type of black swan event) should be viewed as a buying opportunity for anyone underweight equities.
Moving on, here in the States we’ve seen a massive year-end surge in the Transports (second chart below), which has resulted in yet another Dow Theory bullish reconfirmation. Both the Industrials and Transports remain within striking distance of all-time highs.
You may not realize it, but one of the most important facets of Dow Theory is the notion that the prior signal remains in place until a new signal is confirmed. In other words, we give the benefit of the doubt to the most recent confirmation – even through all the subsequent divergences, non-confirmations, and trendless price action – until that signal is either reconfirmed or the opposite signal is confirmed.
Why is this so important?
Because think about it: when we have a bullish confirmation, for example, what’s more likely … another bullish confirmation? Or a bearish signal? Considering what you know about business cycles and asset prices, I sure hope you said a “bullish confirmation.”
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That specific tenet of Dow Theory (that the prior signal always receives the benefit of the doubt) is what makes Dow Theory a trend following, as opposed to mean reverting, approach to investing. It’s what allows us to capture all the gains a primary trend has to offer, without being thrown off the bucking bull mid-ride.
I would encourage you to keep this in mind more often, as it can help to calm your emotions when we’re experiencing bouts of short-term volatility.
Next up, let’s take a look at the Advance-Decline Line. Watching market breadth allows us to see a different perspective than what is captured by major averages, but often (as is the case now), that different perspective tells a similar story.
In this case, we can see that market breadth remains strong and that action across the broader NYSE is commensurate with what we’re seeing in major averages such as the S&P 500 and Dow Industrials.
Now let’s take a look at some recent readings on important barometers for future growth. In the chart below, we can see that the strong uptrend in consumer sentiment remains intact.
The latest reading of 96.8 represents a three-month low, but much of this is being attributed to concerns about tax changes. Richard Curtin, the chief economist for the survey, said, “Importantly, the largest decline in long-term economic prospects was recorded among Democrats, which reflected their concerns about the impact of the proposed changes in taxes.”
Either way, consumer sentiment remains strong, and this bodes well for the future economic activity.
The latest reading in the ISM non-manufacturing index also supports continued growth. While November’s reading of 57.4% wasn’t quite as strong as October’s 60.1% (a 12-year high), any figures above 55% represent strong growth.
This is particularly important when you consider that 8 out of every 10 persons employed in the US are employed in the service sector. The November data also showed 16 of the 17 industries tracked remain in expansion mode, another signal that the economy continues to fire on all cylinders.
Finally, I’d like to give you another glimpse at the yield curve. Below (on the left side) you can see the current slope of the yield curve in red, with its shadow (previous slope) outlined in black.
Looking at the yield curve this way makes it very easy to see the “flattening” that has occurred recently. You’ve no doubt heard much about this, considering it’s been one of the main topics floating around financial media over the past few weeks.
A flattening yield curve generally does not portray great things for the economy, but it’s also not a death sentence. As discussed previously, this flattening has been the result of the Federal Reserve tightening policy (raising the federal funds rate) in an environment that is absent strong inflationary forces (which would drive the long end higher).
I found it rather odd that in a recent economic research paper put out by the Federal Reserve Bank of San Francisco (on November 20th, 2017) they stated the following (emphasis mine):
Recently, the FOMC has been raising the federal funds rate target, though less frequently and starting from a lower level compared with the 2004–05 period. Since December 2016, the target range has been adjusted three times by a total of 0.75%. In addition, the FOMC began reducing the sizable holdings of Treasury and mortgage-backed securities (MBS) that the Fed had accumulated through its large-scale asset purchase programs between 2009 and 2014.
During such an episode of ongoing monetary policy tightening, long-term Treasury yields would usually be expected to rise. Since December 2016, however, they have not only not risen, but instead have fallen quite noticeably, to the surprise of professional forecasters.
Umm … can you please tell me which “professional forecasters” they’re talking about? Apparently, I’m not included because I’ve been making this case for years … most notably here and here.
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I point this out for two reasons: the first is to appease my ego, which (as many others in the financial space can attest to) is repeatedly used as a punching bag by short-term volatility. The other reason – the important reason – is to point out the difference in perspective between economists and market “students.”
Admittedly, I do straddle the fence somewhat, but in my opinion, this is a perfect example of how theoretical models often fail when they meet the real world. Sure, interest rates across the board “should” move higher based on the following logic proposed by Greenspan (and others):
The simple mathematics of the yield curve governs the relationship between short- and long-term interest rates. Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year US Treasury notes even if the more-distant forward rates remain unchanged.
But as you and I both know, this is a bunch of BS! Watch the markets for a little while, take a moment to understand investor psychology, and you’ll see very quickly that this is not how markets behave.
But alas, I guess that’s the beauty of markets, as any trade requires two parties who both think they’re right to engage in opposite directions. It would just be nice if the Fed would perhaps listen to the markets a bit more … as they have a strong tendency be right whenever a disagreement occurs.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.
