DAY HAGAN RESEARCH UPDATE
HOW DO WE DETERMINE THE SHORT-TERM OUTLOOK?
A few of the main model and indicator inputs that we use to determine our Short-Term views on the U.S. equity markets.
Donald L. Hagan, CFA
December 15, 2016
PDF COPY OF ARTICLE
In this Research Update, I thought it would be helpful to show you a few of the main model and indicator inputs that we use to determine our Short-Term views on the U.S. equity markets. (The Short-Term Outlook is generally 1-4 weeks, an Intermediate-Term Outlook is 1-6 months, and a Long-Term Outlook is more than 6 months).
It is important to note that each time frame's outlook is based on quantitative, unemotional, and objective evidence. In other words, our goal is to "overweight evidence and underweight emotion."
The first three charts below were developed by Ned Davis Research (where I started my career in 1988). Each model and series is designed to identify periods as low risk or high risk using measures of sentiment and technical evaluations. NDR has a saying: "Go with the flow until it reaches an extreme and reverses." The goal with these charts is to go with the flow, but when extremes are identified, it's likely time to act. Keep in mind, these indicators are shorter term in nature and tend to shift quickly.
As you can see in the previous chart, when the NDR Daily Sentiment Composite has been "Excessively Optimistic," the S&P 500 has actually declined at a -10.36% annual rate since 1994. I know it sounds counterintuitive to sell when there is excessive optimism, but the idea behind sentiment is that markets can, and do, run too far too fast—which often leads to reversals from those extremes. Note that when the Sentiment Composite is in the "Excessively Pessimistic" zone, the S&P 500 has actually gained at a 32.08% annualized rate since 1994. Also important is the fact that the Sentiment Composite has been in that zone 27.41% of the time since 1994, which supports the statistical validity of the composite—i.e., it's not a random occurrence.
NDR defines the Daily Sentiment Composite as a composite of indicators based on "sentiment, asset flows, overbought/oversold, valuation, volatility and put/call areas of the market. The techniques used in building the indicators and model uses standard deviation brackets, showing how far an indicator's current value is away from a moving mean." In other words, the indicators' ranges are dynamic and adapt with the markets.
The NDR Crowd Sentiment Poll, below, is more focused on sentiment and evaluates different advisory services, surveys of investors and traders, market-related measures of sentiment such as put/call ratios, and relative holdings in bullish and bearish funds. As you can see by the arrows in the top clip of the chart, it's worth paying attention to this chart when it reverses from extremes. Also note that when this model is above 61.5, which indicates Extreme Optimism, the S&P 500 return has been just 1.8% annualized versus 9.6% when the composite is below 55.5 and evidencing Extreme Pessimism.
NDR's Eight Indicator Model, below, incorporates sentiment, but also includes interest-rate-sensitive indicators (which are used to call the stock market), as well as market breadth and commodity momentum. In my view, it provides the additional perspective of "non-equity" markets and how they have historically influenced stock prices and trends (sometimes referred to as intra-market analysis). Again, you will note in the statistics tables at the bottom of the chart that there is a clear delineation between the S&P 500's performances when the model is bullish versus when the model is bearish.
The next chart is from Sentimentrader. Sentimentrader also uses diverse sentiment gauges to define the "bullishness" or "bearishness" permeating the markets and attempts to identify extremes.
There are hundreds of indicator series that are tracked, but my experience is that rather than picking one or two favorites, using their composite provides the most value. Shown in the next chart are the percentage of Indicators at an Extreme, measuring both percentage of indicators at bullish extremes and percentage of indicators at bearish extremes. My view is that when the percentage of indicators showing extreme optimism is over 40% and the percentage of indicators showing extreme pessimism is below 5%, it is prudent to be cautious (I've added arrows to show recent examples). Conversely, if the percentage of indicators showing extreme pessimism gets above 20% and above the percentage of indicators showing extreme optimism, it's worth looking for buy candidates.
Along with these composites we consistently review trader positioning (commitment of trader data, commercial hedging), cash builds, volatility measures (put/call, SKEW), fund flows and other models defining the breadth and strength of the most recent market moves (think McClellan Oscillator, New Highs/New Lows, and others).
All in all, when you hear us describe the Short-Term Outlook as oversold/bullish/excessively pessimistic, neutral, or overbought/bearish/excessively optimistic, the process behind the determination involves the aforementioned factors.
If you have any questions or would like more detail, feel free to call anytime.
Have a wonderful week,
Donald L. Hagan, CFA
Day Hagan Asset Management
Day Hagan Investment Research
— Written 12-14-2016
Note: Charts courtesy Ned Davis Research Group and Sentimentrader.
The S&P 500 Index is based on the market capitalizations of 500 large U.S. companies having common stock listed on the NYSE or NASDAQ. The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values. Indexes are unmanaged, fully invested, and cannot be invested in directly.
Disclosure: The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Day Hagan Asset Management (DHAM), any of its affiliates or employees, or any third party data provider, shall not have any liability for any loss sustained by anyone who has relied on the information contained in any Day Hagan Asset Management literature or marketing materials. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before investing. DHAM, accounts that DHAM or its affiliated companies manage, or their respective shareholders, directors, officers and/or employees, may have long or short positions in the securities discussed herein and may purchase or sell such securities without notice. DHAM uses and has historically used various methods to evaluate investments which, at times, produce contradictory recommendations with respect to the same securities. When evaluating the results of prior DHAM recommendations or DHAM performance rankings, one should also consider that DHAM may modify the methods it uses to evaluate investment opportunities from time to time, that model results do not impute or show the compounded adverse effect of transactions costs or management fees or reflect actual investment results, that some model results do not reflect actual historical recommendations, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, the performance of DHAM's past recommendations and model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.