Day Hagan Research Update




Bull markets don't die of old age, but they could die of starvation.


Neil Leeson


February 17, 2017


Wall Street pundits have many trading quips, quotes and rules that become popular at different points in the business and market cycles. The current catchphrase of the day has been that bull markets don't die of old age. Typically, you need a catalyst for a bear market (decline of greater than 20%), such as significant monetary tightening, financial crisis, recession, war or natural disaster. As shown on the chart below, the S&P 500 Index has gone 162 days without a five percent correction and over 2,000 trading days without a 20% correction or bear market (the second longest since 1928). But we're aware of two other popular adages currently gaining popularity with financial soothsayers: "Buy the dips" and "Don't sell the rallies"—a sure sign of investor optimism. We think it would be quite positive for there to be some type of consolidation or pullback, but given the lack of bearish catalysts, we would view such decline as a potential "buying opportunity".

S&P 500 Number of Days Before the Start of 5, 10, and 20 percent Corrections

Quite often investors will say one thing, but do the opposite. In essence, like any product, prices are a function of supply and demand. Below is a chart that shows the volume behind stocks being bought (demand) and the volume on the sell side (supply). This indicator provides a gauge of advancing volume relative to declining volume over an extended period of time. As shown in the performance box of the lower clip, the market tends to do much better when demand is outpacing supply. However, over the past few weeks, the relationship between supply and demand has stalled, suggesting that there are just as many sellers (supply) of stocks as there are investors that are buying (demand). We are watching this closely.

S&P 500 Index vs. NDR Supply and Demand

Despite the slowdown in demand as measured by the aforementioned indicator, investors remain extremely optimistic. As shown below, the NDR Daily Trading Sentiment Composite currently sits at a 33-day high. Sentiment has remained in the optimistic range (above 60) since the week after the November elections. Typically a reversal in sentiment would be a sign that investors are becoming less optimistic on the prospects for the equity markets.

S&P 500 Index vs. NDR Daily Trading Sentiment Composite


In aggregate, sector sentiment is just as optimistic as overall market sentiment. Five out of the 11 sectors show high optimism (Financials, Industrials, Materials, Technology and Energy), four are neutral (Telecom, Health Care, Discretionary, and Staples) and the remaining two sectors show investors are slightly pessimistic (Real Estate and Utilities). Below is a chart showing the Ned Davis Research Sentiment Rating for the Financials sector ETF (symbol: XLF). This indicator measures the underlying sentiment of the component stocks that make up the ETF. As shown, this indicator has reached extreme levels of optimism. Financials, along with the other optimistic sectors, are areas where investors may want to limit their exposure since not only are investors extremely optimistic, all of these sector funds are extremely overbought as well.

Financial Select Sector SPDR Constituent Sentiment Rating

While the duration of market advances are not a good indicator of extremes, overbought and oversold metrics coupled with sentiment measures are. While a bull market may not die of old age, it can die because of euphoric extremes. Therefore, sector measures suggest that the underlying internals and sentiment are warning that a potential setback is in the offing. None of us know what type of pullback to expect, but we do remain defensive given that the rubberband in some areas of the domestic market is getting stretched.

However, major bear markets are typically associated with the business cycle and significant deterioration in economic growth, job creation and consumer spending (i.e., recession). But based on a composite of macroeconomic measures of state conditions (next chart), the majority of economic models and indicators we track don't suggest that the U.S. is in any danger of recession at this time.

U.S. Recession Probability Model Based On State Conditions

And on a global basis, the risks of a global slowdown have diminished significantly, as illustrated by the Global Recession Probability model, and have moved into the "Low Recession Risk" zone.

Global Recession Probability Model

While we may not be threatened by a global or domestic recession at this time, we do have several price- and valuation-based indicators suggesting that some type of market reset is in order. To be clear, we don't need a significant correction to reset most of these indicators. A mere consolidation phase or an extended period of weakness or flattening of the market would do the trick. In sum, we would prefer to add to current positions when investors are more fearful than greedy, when prices are more in line with valuation and when prices are not typically at longer-term overbought extremes.

In our view, a small correction or pullback would be identified first by sector rotation into more defensive areas where investors are currently more pessimistic (defensive sectors outperforming), and out of sectors at overbought and optimistic extremes.

We are currently watching ratios of specific ETF relationships (Utilities relative to Financials, for example), to identify a change in sector leadership. As shown below, the Financials sector has been significantly outperforming the Utilities sector since last summer. A reversal in this ratio, confirmed by a move above the 100-day moving average (dashed black line), would be an indication that investors are shifting from offense to defense.

Utilities Select Sector SPDR Fund Total Return vs. Financial Select Sector SPDR Fund Total Return

In addition to sector ratios, we are monitoring the relationship between large-cap growth and value indexes and ETFs. Typically in the latter stages of bull markets (if that's where we are) investors tend to move to more valued-oriented areas of the market. As shown, the ratio of IWF (growth fund) to IWD (value fund) has favored growth this year after favoring value for most all of last year. Last year's shift to value coincided with the higher probability of a global recession shown on chart IE90 above. When that expectation diminished, growth started to improve and outperform relative to value. A shift in this trend would suggest that investors are becoming less optimistic on economic and equity market growth.

iShares Russell 1000 Growth Total Return vs. iShares Russell 1000 Value ETF Total Return

Have a wonderful week,

Neil Leeson
Day Hagan Investment Committee Consultant
Day Hagan Asset Management

Written 2.16.2017

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