We started talking about our “Five Factor Framework” back in 2009. A client of ours asked that we read Jack Ablin’s book, “Reading Minds and Markets” and we did. In that book, Ablin discussed various metrics for determining when he thought the market would deliver good or substandard returns.
Although we do not advocate the average investor using these factors individually or collectively to time the markets, we do think they can help us prepare mentally for what may turn out to be challenging or volatile markets. As the old Holiday Inn ads used to say, “the best surprise is no surprise.”
"The five factors that we consider are leading economic indicators, market trend, monetary conditions, market sentiment and valuations."
The five factors that we consider are leading economic indicators, market trend, monetary conditions, market sentiment and valuations. We use inputs from multiple sources to color code each of the factors green, yellow or red. The dashboard we create using this methodology (and update at the end of each month) offers us a quick way to determine if the equity markets are in for smooth sailing or turbulent times.
To be clear, if our indicators show more red lights than green, we are not suggesting that you need to change your long term asset allocations. More red lights than green might suggest that returns over the next six to eighteen months could be lower than long term averages or volatility might be higher.
It is important to remember that these are economic indicators and the economy is not the market. There have been times when the economy slowed down and the market continued to advance. Conversely, there have been times when the economy was in good shape but the market declined.
As we move into November 2018, two of our indicators are turning red like the leaves on many of the oak trees. Our leading indicators of the economy are picking up on the fact that this time a year ago the economy was surging post-election on the promise of tax cuts, spending increases and regulatory roll backs. Now that we have largely realized the benefits of those campaign promises, we need another jolt of stimulus to keep going at the same pace. Add in the potentially negative impacts of rising interest rates and the uncertainty associated with tariffs and you have a new red light on your dashboard.
Also turning red at this writing (October 30, 2018) is our market trend indicator. We chart the S&P 500 Index versus its 12 month moving average (12 MMA). When the Index is above the 12 MMA, we say we are in an uptrend and color the indicator green; when the index is below its 12 MMA we say we are in a downtrend and color the indicator red. At the end of September, the 12 MMA stood at 2731.54.
Source: Bloomberg
The three remaining factors, monetary conditions, market sentiment and valuations are unchanged from the previous month and are colored yellow, red and red respectively. Monetary conditions are suffering from a combination of rising interest rates and the run off of the Fed’s balance sheet. Investor sentiment had been elevated prior to October’s sharp decline and may be expected to turn yellow at some point. Valuations will improve as prices decline, assuming earnings expectations remain unchanged.
While all the red lights on our dashboard may cause some heartburn in the short run, please stay focused on your long term objectives and the asset allocation you have developed to achieve them.
