Author: Christopher P. Hendrix, CMT Page 10 of 11

Myths are stories that often have some element of truth in origin, but over time, take on untrue characteristics. Wall Street is no exception as investors often hold tight to methods that appear to be helpful short-cuts to wealth but often fail when viewed from other angles. At the beginning of the year, investors talked up the “January Barometer” as this year’s selloff in January supposedly would forecast a bad 2016. The Super Bowl winner, coming from the AFC or NFC, can predict performance. Another story this time of year is, “sell in May and go away”. The moving average Death Cross and the Hindenburg Omen are other popular yet dubious Wall Street myths. Investor sentiment is a broad category that spawns numerous myths. At the core of many of these is the belief that bullishness is tied at the hip with low volatility and when together, they display a high degree of optimism, then leading the market to collapse.

Myth: Bullishness tied with extended low volatility leads to market collapse

Sentiment can be measured in many ways. This discussion will cover only a few sentiment measures for the stock and bond market. Major categories citing investor sentiment include surveys, volatility, and spreads.

Market Vane is an organization that surveys investors, tracking if the respondents are bullish or bearish toward specific stock market indexes and other investment choices. Readings at 50 convey a 50% response of bullishness and thus a neutral reading. Levels above 70% bullishness have not been seen since 2007, so above 60% is a modern interpretation of extreme bullishness. Notice how the Market Vane readings above 60 appeared to have stopped the S&P 500 Total Return Index in its tracks back in November and December 2015 and again as recently as April of this year. The evidence presented in this chart supports the idea that extremes in bullishness mark highs in the stock market.

Now let’s go back to late 2014 and the summer of 2015. Points 1 and 2, respectively, display sharp market corrections. Did the correction occur following extreme bullish readings from the Market Vane S&P 500 Index survey? Absolutely! As mentioned earlier, myths are often founded in some element of fact and that was the case for these two examples. However, like the boy who cried wolf, extreme investor bullishness was visible for many months prior to the corrections as the S&P 500 worked higher. This is just one example but the claim of extreme bullishness warning of an impending market correction may have a nugget of truth, but care needs to be given when embracing the message as immediately useful. If the Market Vane reading reaches over 60 in the future, odds favor that we will once again hear the myth of a market correction being at our doorstep.

Another popular measure of investor sentiment is the CBOE Volatility Index, commonly referred to as the “VIX” – most data vendors have the letters V-I-X within their version of the symbol. Generally speaking, the VIX conveys the implied volatility component embedded with S&P 500 Index options. While the VIX is by far the most popular, this measure exists for numerous indexes and investment choices. Investors eager to buy options during periods of increased volatility tend to pay inflated option premiums relative to periods of lower volatility. Think of it like how someone seeking hurricane insurance as a storm approaches would likely pay higher insurance premiums than if no storm was predicted. Therefore, the VIX tends to decline as investors become more bullish and rise as investors become more fearful. This explains why the VIX is also called the “Fear Index or Indicator”.

The myth is that a low VIX precedes market corrections.

Remember, the word “myth” is not being defined as outright false but has a measure of false or exaggerated claims. The chart above supports the myth in multiple periods. The lower portion of the chart displays a horizontal line at the 15 level, what many would claim as a low number historically – at least according to myth. Sub-15 readings preceded the S&P 500 TR Index corrections in August, 2015, January 2016, and the loss of momentum in April to present May.

Now let’s go back to 2013 through 2014. The VIX not only reached below 15 but stayed under that line for months at a time while the S&P 500 TR Index continued higher. Not shown, but this was also the case during the bull market environment from 2005 through the first half of 2007.

Next stop is a sentiment gauge within the bond market, specifically the high yield market. The yield spread measures yields from treasuries, usually the 10-year T-Bond, versus high yield bonds. Spreads widen when investor fears heighten, sometimes for valid, longer-term reasons and sometimes for short-lived, emotional ones. Ideally, a favorable environment has declining trends in yield spreads which is the case currently. With this example, we will avoid directly noting a widespread myth but some common concerns are to be addressed. In the first half of 2015, yield spreads were falling as the high yield index rose to test the previous highs from mid/late 2014. The fast rise and perceived resistance would have been reasonable concerns brought up by investors. Those concerns alone, however, would have provided a flimsy argument despite the accuracy evident by the failure of the trend. So far in 2016, the high yield index has accelerated sharply and is now near potential resistance of the previous highs – a very similar situation to early 2015. Using this level of the yield spread as a gauge of investor bullishness, its current level is not sending the message of over-exuberance.

If we turn our attention to a longer-term chart, the current yield spread in the mid-5’s is not only far from the lowest levels, but lower levels can be maintained for long periods of time while uptrends in the high yield market persist.

Clues brought to our attention by various sources should not be totally disregarded, but myths tend to persist because many are taken at face value as being true.

In the three examples presented, arguments can be made that warrant attention in the current market environment, based on successful but narrowly focused historical examples. Savvy investors develop habits of investigation and research that often bust long-held Wall Street myths.

Disclosures

S&P 500 TR Index: is a capitalization weighted index of 500 stocks representing all major domestic industry groups and assumes the reinvestment of dividends and capital gains. It is not possible to directly invest in any index.

Barclays US High Yield Very Liquid Index: This benchmark includes publicly issued U.S. dollar denominated non-investment grade, fixed-rate taxable corporate bonds that have a remaining maturity of at least one year, regardless of optionality. The bonds are rated high yield (Ba1/BB+/BB+ or below) using the middle rating of Moody’s, S&P, and Fitch, respectively (before July 1, 2005, the lower of Moody’s and S&P was used). Included issues consist of only the three largest bonds from each issuer that has a minimum amount outstanding of $500 million or more (face value) and less than five years from issue date.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Spectrum Financial, Inc. in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Spectrum Financial, Inc. expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing. For full disclosure please see disclosures page here.

How to Gain Insights in the Markets

By Christopher P. Hendrix, CMT

On April 22, 2016

In Market Research

Not all equity markets around the world move together but there is an influence, or correlation, generally speaking.

World equity markets began the year already in a correction, with additional sharp declines in January, see chart below. However, since mid-February the MCSI All Country World Index (MXWD) has been in rebound mode within its downtrend, and recently broke above its downtrend-line . Traditional chartists would likely view such a break as a positive development.

Perhaps this “new” development is not so new if looking at the right clues .

CLUE #1 Momentum of Comparative Strength

A common technique is to compare one investment to another. There are many different ways to do this; we are going to talk about one. The chart below displays the MSCI All Country World Index and the S&P 500 Index. The indicator in the middle goes beyond the traditional relative or comparative strength line by showing the momentum of the comparison between whatever is selected for comparison. This allows us to see if one is gaining momentum or losing momentum versus the other.

In this case a rising indicator, signaled by the purple line simply going up, would imply an improving pace of the MXWD versus the S&P 500.

It is important to state a rising line does not always mean the All Country World Index is going up faster than the S&P 500. It can mean it is simply going down at a lesser rate and thus, have a rising relative or comparative strength metric.

A moving average (blue line) has been added to the raw Momentum of Comparative Strength (MoCS) line in order to help define rising and falling periods. This is an example of adding more than one type of analysis tool.

When the MoCS line (purple) is above its moving average (blue), the World Index is displaying a clue of leadership. Looking at the MXWD, those price bars are highlighted in purple.
The black price bars on the MXWD are periods of lagging relative performance to the S&P 500.

Conclusion #1: The break above the downtrend line is not the FIRST clue!

Even though the break above the downtrend line just occurred, the current phase of comparative leadership versus the domestic market (S&P 500 Index) has been since very early March. What some have perceived as a recent development is not so recent.

CLUE #2 Know the markets’ tendencies & what ties them together

Now let’s look at foreign markets from a different angle. The 2-year chart below shows the downtrends of the developed markets, emerging markets and oil prices.

As mentioned earlier, equity markets around the world have a tendency to move in the same general direction but with differing intensities.

This can be seen in the chart below with emerging markets and developed markets.

Emerging markets tend to be more sensitive to changes in investor psychology. A reason behind the tangible (fundamental) and psychological (technical) influence is the connection of oil prices to emerging markets. Many of these countries are heavily reliant on export revenues from oil and related products.

Conclusion #2: Emerging markets had a more aggressive rebound than developed markets since early February due to oil’s corresponding rebound.

Improvement in oil prices usually have outsized positive effects on emerging markets which in turn, can cause emerging markets, or foreign stocks as a whole, to take leadership roles relative to domestic equity markets.

CLUE #3 Breadth

Clues can also be found within breadth measures. Breadth diversely assesses the movements of components making up an index. Examples of components are the 500 companies that make up the S&P 500 Index. Breadth information is usually derived from the following:

Advancing issues & Declining issues (example: 400/500 companies on the S&P 500 are increasing while 100 are declining)
New 52-week highs & New 52-week lows
Trade volume of advancing issues & Trade volume of declining issues

The McClellan Summation is a common breadth indicator that measures the momentum of advancing issues to declining issues. Logically, a lower number of components carrying the performance burden would assume to have lower odds of maintaining that supportive role for very long before failing. So, users of this indicator attempt to determine if an index may be rising due to only a few issues or if the workload is being more broadly spread out among the indexes’ components.

The Emerging Market McClellan Summation indicator has been generally rising since late January of this year, shown in the chart below.

Its improvement sent the message that the components were getting more organized, so to speak. This breadth indicator was able to add another piece to the puzzle which we would not have if looking only at the price movement of the Emerging Market Index. Bullish clues from this indicator occurred well ahead of the very recent break above the downtrend line of the MSCI All Country World Index as seen in the first chart at the beginning of the article.

Final Conclusion: Clues give market insight

Insight: the capacity to gain an accurate and deep intuitive understanding of a person or thing.

First and foremost, investment risks associated with downtrends should not be under-estimated. However, clues may exist that can help investors further define if the odds of potential reward are high enough to become invested- to some degree- versus not participating at all until a “new” obvious trend change is seen. If you want to know why this could be important, please contact our office and we would be happy to talk with you.

Disclosures

MSCI All Country World Index (MXWD) is a capitalization weighted index that monitors the performance of stocks from around the world.

Standard and Poor’s 500 TR Index (S&P500) is a capitalization-weighted index of 500 stocks representing all major industries.

Bank of New York Mellon Emerging Markets 50 ADR Index. The Index is capitalization-weighted and designed to track the performance of approximately 50 emerging market-based depositary receipts.

Bank of New York Mellon Developed Markets 100 ADR Index. The Index is capitalization-weighted and designed to track the performance of approximately 100 developed market-based depositary receipts.