Revisiting Staples vs. Discretionaries

 

In our August 25th blog, we pointed out that discretionary stocks had take a lead over the more conservative staples. Since that update, discretionaries have surged while staples appear to have fallen off a cliff of relative performance. See the chart below:

Outperformance of discretionary stocks underscore that the "risk-on" trade is "on."  Another confirming indicator included in our chart is the strength in copper prices.  Copper tends to be viewed as an indicator of economic activity, which one would expect to correlate with discretionary stocks.  Note the jump in copper prices (bottom section of the chart) occurred in early 2012 just as discretionary stocks (purple line) took off .  Staples had peaked in December. 

How have these indicators behaved over the longer term?  Below is a weekly chart of the same indicators since 2005.  Note the bounce in copper at the start of 2009 coincided with a surge in discretionaries.  Interestingly, staples meandered in a trading range of relative strength. 

 

 



 

This rather lackluster performance in staples perhaps indicates that such stocks are a parking lot for cash to earn dividends and remain "risk-off" while market uncertainty prevails.  There was certainly quite a surge in staples in October 2007 as the financial crisis continued. But staples underperformed discretionaries since early 2009, suggesting that investors would have been better off watching the relationship between these two indicators, confirmed by an economic measure such as copper prices, to gain better relative returns.

Discretionaries Outperform Staples: Is the Risky Trade Returning?

Staples and other conservative, higher-yielding stocks have outperformed the broader market since May.  The chart below shows the S&P500 as the horizontal black line, with Staples (orange) and discretionaries (purple) either outperforming or underperforming the S&P500 (depending on whether the orange or purple line is above or below the black S&P500 line).

Discretionaries peaked in April and have underperformed vs. Staples until recently. Staples peaked in mid-July. In mid-August, we have seen discretionaries bounce above their moving average as staples did the opposite, possibly hearkening a revisit to the risk-on trade.  Our take is that the run-up in conservative risk-averse stocks has gone a bit too far.  Better values can be found in more cyclical stocks, while dividend-paying stocks have become rather frothy. Not only is this an indication of reallocation into the riskier sector, but it represents potentially more fuel for the continuation of the uptrend.

Indicators such as discretionary and staples relative performance are used weekly in our Baseline Analytics TrendFlex indicator.  Click here to learn how you can stay on the right side of the market trend.

 



Market Breadth Supports the Uptrend

The NYSE Advance/Decline ratio is a useful trend-confirming technical indicator.  Since breaking out in January (see top portion of chart below), NYAD has pushed to a new high.  When such broadening participation in the uptrend develops, it is tough to ignore being long.  Investors are encouraged to stick with the trend when NYAD continues to push higher.

The setback in May was a short-term scare for bulls, as NYAD fell below its 34-day moving average. Likewise, Up/Down volume (the middle chart) also sank below its 34-day moving average.  Tactical asset allocators could have lightened up on long positions upon this warning sign. The 34-day exponential moving average used on these two charts worked reasonably well in timing market decisions, however, this indicator should not be used alone.

Another (among many other) indicator we use to assess the market trend is NYSE New Highs vs. New Lows (the bottom chart). This indicator has meandered higher since bottoming in late May and also supports the current uptrend.

At Baseline Analytics TrendFlex, a blend of technical, fundamental and macro-economic indicators is utilized to define a trend assessment score, helping investors stay on the right side of the market.



Setting Stops Using Average True Range

Setting stops on portfolio positions is often a mixed blessing.  Often, a stop is activated and money is left on the table as the stock continues to rise. One approach is to incorporate volatility and the longer-term trend in determining the stop level or trailing stop threshold. 

The following stop-setting strategy can help an investor stay with the stock’s main trend for as long as possible.  This is an objective-based approach, rather than an approach prone to subjective opinion, enabling the investor to remain honest with himself and his capital.

We are utilizing ATR as a basis of setting stops.  ATR is “Average True Range,” and is calculated based on a stock’s volatility, incorporating recent highs vs. recent lows in a stock’s price.  In the chart below of Apple, the ATR varies approximately from a high of $38 to a low of $10. A simple, objective rule to follow is to use 2x the ATR. There is nothing scientific or “secret sauce” for using 2X other than avoiding daily volatility whipsaws. 

Assuming a buy point of $250 in September 2010 (first blue vertical line), the ATR at that point was $16.  $16 x 2 = $32 stop range, or a stop of $218.  As APPL continues its uptrend, the stop is adjusted at a point where the stock bases, near $325 a share.  At this point, the stop is set just under $300 per share.  This is a simple, mathematical approach that will help the investor avoid arguing with himself about where to set stops.

Similarly, this objective approach can be set with a trailing stop.  Use the same 2X ATR to set the trailing stop and simply let it ride.

We find that using weekly charts and their resulting ATR values are most useful is holding positions as long as possible to maximize gains during an uptrend.  Using ATR as a stop-setting mechanism is a sure way to avoid the trap of guessing when to get out of a position.

As for taking profits (and losses) a prudent strategy is to set such ATR-based stops, but also take random profits (or losses) now and then. An investor can, for example, use the ATR stop strategy on 70% of his portfolio, but apply a concerted profit or loss-taking strategy on the balance of the portfolio.  Markets trend, yet they can also be volatile and easily take away the capital gains that an investor has achieved.

Visit Baseline Analytics TrendFlex, our subscription-based service helping to keep investors on the right side of the market at all times.

Stocks Are Remarkably Cheap By This Measure of Valuation

From an historical perspective spanning the last 55 years, the S&P500 is at a valuation level matching the lows experienced before the launch of the bullish stock market run that started in the early 1980’s and peaked in early 2000.  

To collect this data, I went to FRED, the Federal Reserve Economic Data maintained by the Federal Reserve of St. Louis. I plotted the S&P500 plus a plot of the index divided by seasonally-adjusted After Tax Corporate Profits to arrive at a proxy PE ratio.

 

As the chart below shows, although the S&P500 is 10% below its 2000 peak, valuations today are 71% lower than the valuations reached in 2000 (the blue line is the PE ratio and the red line is the S&P500 index). Note how the PE ratio is aligned with levels last seen in the early-mid 1980’s.  Compared to the 2007 peak, the S&P500 is 12% lower, yet valuations are cheaper by about 30%.

 This data raises a couple of immediate observations:

1.      Stocks are extraordinarily cheap. The significant earnings power that corporations have generated from secular economic trends in productivity and globalization has outpaced stock price growth. It would appear that stock prices need to catch up. At a minimum, it may suggest that stock prices are fairly well-protected on the downside, an opportunity for long-term investors. As historically low interest rates benefit corporations and consumers, as well as raise the risk of an asset bubble in fixed income investments, perhaps stocks are the screaming buy alternative. Many workers who entered the labor force in the early 1980’s (like me) saw stock portfolios rise consistently up to the 2000 peak. Perhaps today’s workforce entrants will experience a similar long-term ride.

2.      Investors are less willing to bid up stock prices commensurate with earnings growth.  This may suggest waning participation from retail investors or simply skepticism and fear that something terrible is about to happen (i.e. the implosion of the Eurozone). Perhaps these historically low valuations are suggesting that stock prices and the financial markets in general are preparing to collapse, warning of a deflationary environment and a market not unlike that experienced by Japan over a 20+ year span. The lack of enthusiasm to bid up prices as earnings grow may suggest a sea of bearishness as well as skepticism and outright contempt of the stock market. But that too feels like a long-term contrarian “buy” signal.

I then took the FRED data and decided to see how an interest rate-adjusted PE ratio compared historically to stock prices.   Since interest rates are so low, and the earning yield relative to interest rates is another popular valuation indicator, I chose to multiply the PE ratio by the Federal Funds Rate, which today is 0.25%, to see how this measure of valuation stacks up historically.

As you can see by the chart below, replacing the blue line in the above chart (our PE ratio) with a line modified by the Federal Funds Rate tells us that valuations are at their lowest in the 55-year history that the Federal Reserve has been collecting this data.

That suggests serious undervaluation of stocks. Such a dismal valuation is either a precursor to Armageddon in the financial markets, or a great secular buying opportunity.

Secular markets have historically lasted 10 to 15 years.  The market peak in 2000 has been popularly considered the start of a secular bear market that is now pushing 13 years in age.  Unless a market rout is in the cards to take this secular bear market to another significant decline to complete the bearish secular trend, today’s valuations suggest that a slow and steady buildup of a portfolio of equities may be a prudent long-term investment strategy, one that rewarded investors following the secular bear market of the 1970’s.

NYSE Breadth Supports Uptrend

Three key market breadth indicators I follow include three views of NYSE activity:

1. Advance/Decline ratio
2. Up Volume vs. Down Volume
3. New Highs vs. New Lows

The NYSE Advance/Decline ratio is the healthiest technically, while the other two ratios are behaving quite well. See the chart below:

The A/D Volume line looks to be pushing to a new intermediate-term high. I find the 63-day exponential moving average a useful gauge of support and resistance. A market breadth indicator such as this provides reassuring support for this upleg in the NYSE index.

Similarly, the NYUD and NYHL are heading in the right (bullish) direction after bottoming in late May.

Besides looking at price charts, measures of market breadth such as this are helpful indicators in assessing the strength of the trend.

More about the blend of technical indicators used by Baseline Analytics can be found here.

VIX and SPX: Using Moving Averages to Assess Trend

One simple indicator to catch the "right" side of the market is a comparison of the S&P500 daily chart with the VIX.  Both are plotted with a 34-day exponential moving average.

Note the chart below.  When VIX is below its 34-day EMA, the S&P500 is generally in an uptrend. When VIX is above its 34-day EMA, as it was starting in early May 2012 through mid-June, the S&P500 was falling.  This signal system will generate whipsaws and is not perfect in any sense.  But it represents yet another simple approach to identifying the major intermediate-term trend so that investors can remain on the "right" side of the market.  Click here to visit Baseline Analytics TrendFlex, which incorporates several indicators like that one below, to identify (and stick with) the major trend.