This Indicator Points To Another Rally. Here’s Why…
We all have to-do lists that grow longer every day. Many of us look at what needs to be done right now, and we deal with things as they become urgent. You could say we have a short-term focus.
For example, as I look out the window, I see tumbleweed piled up against the fence. The wind blows it into the fence, and, in a perfect world, I’d get out there and throw it to the other side so the wind could blow it to Nebraska or wherever tumbleweed goes. If I don’t do that, it weakens the fence, and eventually the fence will need to be repaired.
But the dishwasher also needs to be emptied, and a load of laundry needs to be folded, and three more loads need to be done, and…
Well, let’s just say the fence isn’t urgent, and I am doing urgent chores around the house today. That fence will hold out for years.
Investors — even those who claim to be long-term investors — can often adopt a short-term focus. Even while saying they believe that stocks always deliver gains in the long run, they focus on today’s price changes and they look at daily price charts.
Just like thinking long-term about that to-do list with a long-term emphasis can be useful, looking at stocks with a true long-term focus can be useful. This week, even as I ignore the long-term problem building up on my fence, I want to step back and look at the long-term picture of the stock market.
The Case For Another Rally
Below is a monthly chart of the S&P 500 index, a view some investors rarely look at. It’s bullish.
The past 21 months have been volatile. As the chart shows, the previous 21-month period that shows similarity to this time frame ended in 2016. The index gained almost 25% in the 12 months after the breakout.
The similarity extends beyond price.
At the bottom of the chart is my proprietary Income Trader Volatility (ITV) indicator. ITV captures changes in emotion. In this way, it’s similar to the better-known VIX index.
VIX is based on options prices, and rises when traders are bidding up the prices of puts options, like they do whenever prices fall. Because of that, VIX is known as the “fear” index. As prices rise, fear falls and the VIX index also declines. ITV follows the same pattern, with high readings at important price lows. The indicator (solid grey line) calculates individually for each market index, stock, or ETF. I added a moving average (dashed green line) to provide timing signals.
When the indicator is above the moving average (MA), fear is higher than it has been in the recent past. “Buy” signals occur when the indicator falls below the MA. More details on this indicator can be found in an award-winning paper I wrote about ITV a few years ago.
Right now, ITV for the S&P 500 is on a “buy” signal. It has been for several months, and the indicator shows the same pattern we saw during the consolidation that ended in 2016. Could we be set up for a 25% gain? You may remember that last week I made the case for a gain of at least 10%. That could easily prove to be conservative.
“There Is No Alternative”
That can easily be explained by the fact that we are in a TINA market. TINA means “there is no alternative” to stocks. Pension fund managers and other institutional investors have been citing TINA for some time as the reason for the continuous bull market.
To understand their problem, it could be useful to consider how pension funds are managed.
For a hedge fund manager, the goal might be to maximize returns. This is also the goal of many individual investors. There’s nothing wrong with that goal. But that’s not usually the goal of a pension fund or an insurance company, and these investors control trillions of dollars in assets. For pension funds and insurers, the primary goal is having sufficient cash to meet their obligations. They know, with a reasonable degree of accuracy, how much cash will be needed in each of the next 30 years. Their job is to ensure that cash is available.
In the past, this might have been done with a mix of stocks and bonds. I’m simplifying this idea, but the manager may have placed half the portfolio in bonds and the other half in stocks. If the manager had $100 billion in assets, $50 billion in bonds might have generated $4 billion in income at 8%. That might have covered almost all of their payouts for the year.
It’s important to remember 8% was a reasonable goal for fixed income investors just a few years ago. Investment-grade corporate bonds yielded 7.5% as recently as 2009. An investment manager could add a small amount of junk bonds to the portfolio and achieve 8%. Depending on how much cash was needed, it might be possible that bonds could meet the fund’s objectives and the rest of the money could be invested for growth.
That was 10 years ago. Today, the problem is different. Managers still need to generate cash, but investment-grade bonds yield about 3.9%.
Junk bonds will boost that yield, but risks in that sector tend to be uneven. There will be more defaults during a recession, and the risk management models will limit the amount of exposure to the sector based on the company’s worst-case scenario. To generate the type of returns the pension fund or insurer needs, the manager will reduce the amount of bonds to the lowest possible level and invest the rest in stocks. The reason: TINA. In other words, there is no alternative asset that can deliver the returns they need.
Over the next week, stocks could become even more attractive. Traders expected the Federal Reserve to cut short-term interest rates by 0.25% at the meeting on October 30-31, and that’s exactly what they gog. The chart below shows traders had priced in a 93.5% probability of a cut.
If the Fed didn’t cut, there would likely have been a steep market selloff. The Fed doesn’t want that. So this cut will make bonds even less attractive and could push more money into the stock market.
For now, it is best to remain bullish. The monthly chart above shows we could easily enjoy a year or more of gains. Prices won’t move straight up, so there will be opportunities to profit from short-term down moves. Still, but bulls should enjoy the next few months.
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