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What else needs to happen for this rally to continue?

 

In a prior post, we discussed the phases of an equity bear market and last week we commented on the current rally taking place. In order to move into the next bull market cycle, there are a few longer-term signals that need to turn positive. 

One is earnings estimates hitting a bottom.  The rate of positive earnings revisions in the U.S. has declined to 50%, which is the lowest level since 2008.  However, the consensus estimates for full year 2020 earnings per share growth is -7%.  That seems optimistic given the economic and labor market data that has been reported thus far.  Equity markets are forward-looking and can look through near-term negative earnings, but that typically occurs after earnings estimates are done declining.

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Equity market volatility has been declining recently but is still very elevated.  The earnings, economic, and labor market data are likely going to be negative throughout the second quarter of 2020 and could cause a second spike in equity volatility.  The last time the equity volatility index (VIX) went above 80 was in 2008.  In 2008, the index spiked to 80 on October 27th, receded to a low of 48 on November 4th, and returned to a slightly higher high on November 20th. When the VIX fell below 38 after the March 2009 bottom, it finally started to trend lower as the cyclical bull got underway.  If the VIX index can consistently close in the 30s and drop below 30, the groundwork would be set for another bull market cycle.

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Recently, we mentioned that there have been some positive breadth/volume-based indicators.  These are helpful in determining the rally phase of the bear market cycle.  To move into a sustained bull market, it is supportive to see some corroboration from longer-term signals.  One of those indicators is the equal-weighted equity index returns versus the market cap-weighted returns.  When these return streams are close together, it suggests that there is broad participation in the rally and that multiple companies/industries are experiencing improvement.  Currently, the market-cap-weighted indexes in the U.S. and globally are significantly outperforming the equally weighted versions.  This suggests a small subset of large companies are leading the index higher and other companies have not yet recovered.  Other measures showing the number of stocks and regions above their moving averages or with rising moving averages suggests the same narrow leadership condition. 

Source: Yahoo Finance.

Source: Yahoo Finance

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Ned Davis Research (NDR) has a set of Thrust Indicators that are based on improvements in volume and near-term performance.  They can serve as good leading indicators of changes in near-term momentum and trends, which are helpful for determining when extreme selling events are ending.  They can also potentially get overextended and send false signals that a new bull market phase is starting.  This is especially true after an exceptionally negative period and when there is no corroboration from longer-term signals.  NDR also has a set of indicators that are designed to determine market bottom conditions.  There are instances during large selloffs within short periods of time that these indicators can also send false signals.  This happened after the initial selloff in 2008. 

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A similar dynamic is developing in 2020, as the thrust indicators are positive, but the bottom watch sent a false signal and the rally watch indicators are not yet positive. 

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NDR also uses some indicators to help determine when to be overweight equities versus bonds that incorporate a combination of internal (price-based) and external (economic-based) signals.  After the initial selloff in 2008, this model did not recommend moving to overweight equities until after the March 2009 bottom, acting as a better signal than some of the shorter-term indicators.  This indicator is currently at the lowest level since 2009, suggesting this is not yet a period to be overweight equities.
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When more of these longer-term signals turn positive, along with a shift in leadership to small cap and cyclical stocks (likely accompanied by the expectation for an improvement in economic activity and earnings), this would be a signal from the market that a new bull market phase is starting.

 

Rank Dawson, CFA
Vice President, Investment Strategy

Boyd Watterson Asset Management, LLC

 

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.  The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.