A Misstep in the Bull Cycle and the Missing Steps to An Uptrend
October 08, 2018
Shashi Mehrotra is the Chief Operating Officer and Chief Investment Officer of Legend Advisory and a pioneer in the application of artificial intelligence to the field of investment management.
He is the chief designer of Legend's Asset Allocation Neural Network (AANN). AANN is a sophisticated computer model that uses mathematical algorithms to forecast the relative strengths of different asset classes. Mr. Mehrotra spent over a decade on the research, development, testing and implementation of AANN's state-of-the-art artificial intelligence system.
3rd Quarter 2018 Market Commentary
A Misstep in the Bull Cycle and the Missing Steps to an Uptrend
Our bullish viewpoint has waned in comparison to our enthusiastic outlook over the last decade. While we continue to believe that we are in a secular bull market for equities, we are also in a long cycle which sees shifts in asset classes and sectors during that time. We made some recent portfolio reallocations in response to our models tilting away from equities. Historically, a mid-term election year is a season for volatility and calls for caution. Moreover, we believe that the second derivative of the earnings growth curve may be on the cusp of turning negative which is indicative of an inflection point. In other words, we don’t anticipate negative earnings, but rather a slowing rate of growth causing a pause in the equity markets. Lastly, there are some potential landmines that could take this market into a tailspin for a while. The potential landmines include the trade conflicts over tariffs, mid-term elections, and yield curve inversion. We think most of the U.S. dollar strength is behind us due to the aggressive interest rate increases planned by the Federal Reserve (Fed). The unlikely caveat for the U.S. dollar is if inflation in the U.S. gives a negative surprise then the Fed may have to raise more aggressively. The European Central Bank is on the brink of becoming more rigid with their monetary policy as well.
Every asset class follows its own cycle – and events around the world may affect each class in different ways. Our models currently are slightly bullish on equities and favor domestic markets relative to both foreign developed and developing equities. Among the domestic equities, our model favors Large Cap (LC) stocks over Small Cap (SC) stocks. We are intrigued with this finding by our financial model since we believe that, relative to LC, SC stocks are under-bought and are less at risk of trade and tariff downers. We will continue to monitor asset classes regularly and reallocate as deemed necessary in an attempt to capitalize on potential market opportunities and minimize the impact of market downturns.
5-Step Uptrend Process
As we have mentioned previously, there are typically five steps the market goes through in order to resume an uptrend.
- The market is first oversold, which we saw at the beginning of this year.
- It then displays positive divergences, which happened in the first and the second quarter of this year.
- These two steps are then followed by a failed rebound which we have seen a few times this year and may be in one at the time of this writing (September 13, 2018).
- The next step is a retest of the highs established in late January of this year, which has happened.
- The final step in a successful resumption of an uptrend, is a breadth thrust on the upside. This is still missing.
One variable of particular interest is that we not only had retests of previous highs but have exceeded the high established in late January. However, as we went past this high we never saw the enthusiastic buying similar to the selling we saw in January and February of this year. The rallies that took us where we sit today (at new highs on the S&P 500 Index), have been very narrow (lacking breadth) and apathetic (lacking an upward thrust and breadth) which are not typical of a sustainable rally. Therefore, the rallies in February, March, July, and August failed to produce a breadth thrust signal to satisfy our urge to call the resumption of this uptrend that has been intact for almost a decade. And until that happens we believe that the equity market, particularly the U.S. equity market, will remain stuck between step 3 and step 5 of the aforementioned process. The equity market can still resolve itself on the upside, but we need to watch the tape action over the next couple of months to be convinced.
Shashi Mehrotra, Chartered Financial Analyst, is the Chief Operating Officer and Chief Investment Officer of Legend Advisory. The opinions and predictions expressed herein are those of Shashi Mehrotra solely and not necessarily the opinions or expectations of Legend Advisory or any of its affiliates. Such opinions and predictions are as of September 13, 2018, and are subject to change at any time based on market and other conditions. No predictions or forecasts can be guaranteed.
Current market and economic data is as-of September 13, 2018. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
Important Disclosures and Definitions
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The S&P 500 Index is a capitalization weighted index of 500 of the largest exchange-traded stocks in the U.S. from a broad range of Industries whose collective performance mirrors the overall stock market. Capitalization weighting results in the larger components (stocks) carrying a larger percentage weighting. The Equal Weighted S&P 500 consists of the same stocks but equally weighted and consequently may provide insight into the breadth/disparity of market performance. Investors cannot invest directly in an index.
Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market. Moderate inflation is a common result of economic growth. Hyperinflation, with prices rising at 100% a year or more, causes people to lose confidence in the currency and put their assets in hard assets like real estate or gold, which usually retain their value in inflationary times.
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