DAY HAGAN RESEARCH UPDATE
DEMAND FUELS EUPHORIA
Supply and demand measures suggest that there is more demand than there is supply of stock (i.e., more buyers than sellers).
December 16, 2016
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The chart below illustrates the strong demand for U.S. stocks relative to the supply. The NDR Volume Demand indicator is based on the longer-term moving average of the total volume of advancing issues in the broad U.S. equity market and NDR Volume Supply is a measurement of the volume in the declining issues. The bottom clip of this chart (green line) is the spread between the two series. When the spread is increasing it suggests that buyers are outpacing sellers of stocks. A spread that is declining is a sign of caution. Simply put, this measure tells us if buyers or sellers are in control of the market. And clearly the buyers are in control.
To be clear, the demand/supply spread is not a timing indicator and should not be relied on as such. I consider it both a sentiment and an overbought/oversold indicator. Nonetheless, this measure is getting extended based on historical levels and will be an important input in our investment decisions going forward (watching for a change in trend). But for now, as long as there is more demand for stocks than supply, the market can churn higher, despite valuation, monetary or sentiment concerns.
Like the demand/supply spread, several other sentiment measures are at extremely optimistic levels based on historical analysis. For example, the sentiment composite in the bottom clip of the chart below comprises multiple indicators (sentiment polls, put/call ratios, and mutual fund assets) that have historically been good in evaluating longer-term investor sentiment. As shown, while sentiment is high, it can go much higher before indicating trouble for the equity market. With sentiment it typically pays to go with the crowd until sentiment starts to reverse. Nonetheless, sentiment and the demand/supply spread suggest that the upside may be limited from here and that investors should tread cautiously.
As we have mentioned before, the U.S. dollar is extremely overvalued based on historical purchasing power measures. However, the PowerShares U.S. Dollar ETF (symbol: UUP) is nowhere near longer-term overbought extremes (below). This longer-term measure did signal extremes in early 2015. But since this indicator uses year-over-year historical data, the overbought condition was worked off and now the fund is neutral (neither overbought nor oversold).
As we have written about extensively in the past, the dollar has been a key factor influencing investors' decisions for several years now. Keep in mind that currencies, especially the dollar, are often reflections of the relative global central bank policies that are in place—as well as future actions that are being "touted" by central bank mouthpieces. If a central bank wants to weaken their country's currency in an effort to spur growth and increase exports, they would seek to lower interest rates. If they wanted to strengthen their currency, they would seek to slow down growth (below inflation-inducing levels) and increase their interest rates.
At this point, the U.S. Federal Reserve has hinted that they want to "normalize rates" in an effort to ensure that we have the quintessential Goldilocks economy (not too hot/not too cold). Nonetheless, their efforts are bolstering the dollar's strength, which is an unwanted side effect of a "normalizing" policy. The stronger dollar is a negative 1) for U.S.-domiciled companies' mulitnational earnings and 2) the cost of our exports (the strong dollar makes our exports more expensive and U.S. exporters are at a disadvantage when competing in the global marketplace). So far, the strong dollar has not deterred investor demand for U.S. equities.
Not only are U.S. investors buying, foreigners have come back into the U.S. stock markets. While the data in the bottom clip of the chart below is only through the third quarter, it clearly shows foreign buying of U.S. stocks after several quarters of net selling. And why not, as foreigners have been gaining from both U.S. equity and dollar appreciation this year. Money goes where it is treated best, and clearly that is into dollar-based assets.
While dollar strength is working for foreign investors in U.S. markets, it is not working for dollar-based investments in several developed foreign market ETFs. We currently own emerging market and Asian ETFs that do not hedge the foreign currency exposure. And over the past month, the underlying currencies of these two ETFs (VWO and AAXJ) have actually been strengthening versus the dollar, helping the returns. It has been the weakness in the equity holdings that have hurt these funds. Nonetheless, we are maintaining our exposure to both of these funds as long as flows remain supportive (below)—a sign of investor demand.
In addition to positive flows, emerging market relative earnings growth is clearly more favorable than developed market earnings growth as represented in the MSCI World Index. As I outlined in last week's publication, overall valuation metrics show greater potential for emerging than developed markets, and we think valuation differentials will come into play in the years to come.
In sum, demand remains a dominant factor in U.S. equity markets and has pushed U.S. investor sentiment to optimistic extremes. Elevated levels of euphoria are a warning sign that the upside may be limited and that there is a possibility of some near-term weakness which could remedy the situation.
We continue to look at the markets from a multifactor approach, which has reduced our expectations for further U.S. equity market strength. On one hand we have economic, valuation, sentiment and monetary indicators suggesting that U.S. equities have gone too far too fast. On the other hand we have trend, money flows and demand indicators that continue to favor further strength. While we continue to side with how the markets are acting and not how they should be acting, we remain very cautious with preservation of capital in mind.
Have a wonderful week,
Day Hagan Investment Committee Consultant
— Written 12.15.2016
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