Day Hagan Research Update




Trend and breadth measures remain supportive of equities. However, the upside may be capped by valuation.


Neil Leeson


January 13, 2017


For those who look at internal price-based indicators, the bullish argument is fairly easy to make. There are several domestic and international indexes that are above intermediate-term trend metrics (below), showing both breadth and trend strength on a broad basis. We are seeing multiple examples that market internals are strong.

However, with that strength, we have seen some significant shifts in asset allocation based on ETF and mutual fund flows. Expectations for stronger domestic economic growth have pushed into more cyclical industries. And a stronger U.S. dollar, brought on by higher interest rate differentials and growth expectations, has increased the attractiveness of smaller-cap stocks and companies that depend on domestic revenues.

Therefore, we have adjusted our portfolio accordingly, reducing our international exposure in favor of increased exposure to domestic equity ETFs.

MSCI ACWI EW Index Vs. Percentage of ACWI Markets Above Their 50-Day Smoothings Chart

While the internals of the market remain strong, both fundamental and sentiment measures suggest that caution is warranted. Valuation and sentiment indicators, like overbought and oversold indicators, can become very extended, well beyond expectations, and thus have historically been poor timing indicators. It has always been better to "go with the flow" as long as tape measures confirm.

By most measures, the broad U.S. equity complex is overvalued based on various historical measures. In the bottom clip of the chart below, you can see that the S&P 500 Median Price/Earnings continues to bounce around the overvalued level (+1 standard deviation), which equates to an S&P 500 Index price of 2,162. And just like the indicator has stalled around this overvalued level, so has the market (as I write this blog, the index is a mere 5 points above this level). Can we move higher? Sure we can, just like in 1997 when the median P/E crossed into overvalued territory and remained elevated into the burst of the 2000 tech bubble. If investors would have sold in mid-1997 when we reached overvalued levels, they would have missed out on a 60%+ move into the 2000 market peak.

Prive Move of: -3.4 % to Overvalued (+1SD), -26.1 % to Median Fair Value, and -48.7 % to Undervalued (-1SD)

To be clear I am not arguing that the market still has a 60% move left in it before a significant decline. Rather, I am pointing out that valuation measures warrant watching, but should not be used as the reason to exit a market.


Several weeks ago I showed several sentiment indicators that argued that investors were overly optimistic on stocks and pessimistic on bonds, specifically 10-year Treasuries. Not much has changed from an aggregate stock or bond sentiment perspective.

The chart below shows the NDR Daily Bond Sentiment (bottom clip) at its lowest level since 2006. Like all sentiment indicators, we'd like to see a reversal in this measure to get more enthusiastic about owning U.S. Treasury bonds.

U.S. Treasury Bond Futures vs. NDR Daily Bond Sentiment Composite

However, the sentiment indicator shown above is mainly based on investors' attitude towards bonds. But the chart below argues that investors are not as pessimistic as the polls suggest. This chart measures monthly asset flows into 47 long-only non-leveraged domestic bond ETFs and ETNs. While there has not been a lot of net new buying, there hasn't been any net new selling for the past three months. And while we haven't seen net selling of government bond ETFs, there have been individual issues that have sold off, mainly longer-duration funds.

Composite of Fixed Income: U.S. Govt

Like the rotation in the stock market, there has also been rotation in the bond market. This chart showing the flows into TIP, the iShares TIPS (Treasury Inflation Protected Securities), suggests that investors have not been net sellers, but have rotated into more attractive areas of the bond market given expectations for stronger economic growth.

iShares TIPS Bond ETF (TIP)


In aggregate, most sentiment indicators all agree that investors, small businesses, and consumers are a very optimistic crowd. However, there are several examples of unloved ETFs. And these are the funds to keep an eye on for future allocation once a change in trend is identified and confirmed.

Currently, the greatest investor optimism can be found in the financial stocks. The indicator in the bottom clip is a measure of sentiment based on the individual stock sentiment in the constituents of XLF. As shown, it is at its highest level since 2013, and returns in XLF, when sentiment reaches such extremes, are muted.

Financial Select Sector SPDR Constituent Sentiment Rating

You'll find most investors are pessimistic on retail and real estate stocks. Below is the aggregate sentiment gauge for the underlying stocks in RTH, the VanEck Vectors Retail ETF. This measure is not at extremes, but it does suggest an overall pessimistic outlook. If trend measures improve, this would be an area to consider for future allocation.

VanEck Vectors Retail ETF Constituent Sentiment Rating


The bulls can cite technical and breadth measures, whereas the bears can embrace high valuation, monetary tightening, and too much optimism. We continue to take a disciplined approach and maintain a high cash reserve. We feel that there will be better opportunities down the road if and when earnings and economic growth meet or exceed euphoric expectations.

Have a wonderful week,

Neil Leeson
Day Hagan Investment Committee Consultant
Day Hagan Asset Management

Written 1.11.2017

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