Day Hagan Research Update




Three steps and a stumble may not play out this time given the pace of interest rate normalization.


Neil Leeson


March 13, 2017


For most of 2017, sentiment measures have been signaling that investors were excessively optimistic. However, those extremes are starting to show signs of reversal, indicating that investors are becoming a little less greedy. Sentiment has historically been a crowd-following indicator, and we've found that the best way for investors to utilize this type of information is to go with the flow until it reaches extremes and starts to reverse. As shown below, the Ned Davis Research Group's short-term sentiment composite has now reversed from depicting excessive optimism to neutral. This composite indicator measures sentiment in a variety of ways: polls of investor sentiment, put/call ratios, volume metrics, etc. A move in this indicator suggests that the mood of market participants has become less enthusiastic. We will continue to watch this indicator closely and start to add equity exposure as this and other indicators suggest that investors are becoming excessively pessimistic, providing that no major crisis or economic event is poised to derail the secular bull market in equities.

In addition to short-term sentiment, longer-term measures are also showing signs of reversal. The NDR Crowd Sentiment Poll model attempts to gauge sentiment over the next six to 12 months. Historically, it has been a very powerful indicator. However, tops and bottoms (arrows shown below) are selected in hindsight, limiting this indicator's use as a timing model. Nonetheless, caution is warranted because on average, from optimistic extremes to pessimistic lows, the S&P 500 index has given up 160 points (median is close to minus 100 points).

Sentiment among investors may be ebbing, but consumer sentiment regarding their present situation and future expectations remains strong. The chart below compares consumer sentiment with bond prices. As you might expect, the indicator shows that increasing confidence in the economy is a negative for bonds (suggesting higher yields). Currently, we have limited exposure to bonds and will monitor consumer confidence going forward as a gauge of confidence in the economy and the presidential administration's potential policy changes.

As far as stocks go, Ned Davis Group's sector team put out a table last week showing the historical performance of sectors during periods of high consumer confidence.

S&P 500 Sectors Mean Gain % Median Gain % % Cases Outperforming
Health Care 33.1 9.1 100
Consumer Staples 18.6 7.6 83
Information Technology 15.2 6.2 67
Energy 13.6 2.4 50
Telecom Services 10.6 5.7 50
Consumer Discretionary 9.0 2.6 50
Utilities 6.1 9.3 50
Financials 9.6 0.4 17
Industrials 8.7 1.4 17
Materials -1.5 -2.2 17
S&P 500 Index 12.7 5.4 n.a.
6 Cases: 11/30/1972 to 07/31/1973, 04/28/1978 to 12/29/1978, 09/30/1987 to 07/31/1990, 08/30/1996 to 10/31/2001, 04/28/2006 to 10/31/2006, and 12/30/2016 to 02/28/2017. A period of high confidence is when the 6-month average of the Conference Board's Consumer Confidence Index is above 104. Source: S&P Dow Jones Indices.
Ned Davis Research Group T_ILC201703021.1

As shown in the table, the Health Care Sector has had positive gains for each six-month period following those times that the consumer confidence index moved above the 104 level. Despite concerns around health care reform and drug pricing, the Health Care sector ETF (XLV) has been one of the best performers on the year. And based on the continued investor inflows into the sector, investors remain optimistic on the prospects for further appreciation of health care sector stocks. Addtionally, if you look at the underlying valuation of the stocks in XLV, they aren't historically overvalued. Further, longer-term mean reversion measures suggest that the ETF is neither overbought nor oversold at this time (second chart below). Based on the indicator evidence, Health Care is one area we will consider adding exposure to on weakness.


Most measures suggest that the Federal Reserve is set to raise short-term rates this week (around a 96% probability based on futures pricing). Another increase in rates would mark the third time they have done so in this cycle. Historically, studies have found that after three rate increases by the Fed, stocks tend to decline—"three steps and a stumble" (below). However, though I hate to say "this time may be different," we may actually be in a different environment this time around. First, fed funds rates started from near zero percent; second, the economy remains in a slow growth trend; and lastly, the previous two rate hikes have been almost one year apart and were increased in minimal increments of 25 basis points. Our view is that if rates are increased this week and the markets sell off in response, and it is enough that our shorter-term sentiment measures move into excessive pessimism levels, it may provide a good entry point to increase our exposure to domestic equities.

Dow Jones Industrial Average Performance After Three Steps and a Stumble Sell Signals


Decline to Near-Term Low Decline to Bear Market Low
Signal Date Percent Days Percent Days


-24.8 92 -46.6 540


-1.3 2 -4.4 396


-15.5 120 -43.3 273


-5.4 28 -17.0 378


-4.7 81 -10.0 239


-7.6 22 -11.5 533


-1.3 16 -7.1 415


-8.0 113 -20.8 213


-3.1 69 -29.7 502


-10.7 76 -39.4 403


-5.4 35 -5.4 35


-5.0 4 -18.8 425


-0.1 3 5.3 412


-0.6 2 108.2 1104


-10.4 76 -24.7 462


-4.8 24 -27.1 1111


____ ____ ____ ____


-6.8 48 -12.0 465


-5.2 32 -17.9 414

A near-term low is the DJIA's lowest close within a 126 market day period following a sell signal. A bear market low is the first NDR-defined bear market low following a sell signal. Discount rate, margin, and reserve requirement increases all qualify as steps until 1993, then Fed Funds Target rate. Days = Market Days.

NED DAVIS RESEARCH, INC. T_525 10/04/2011

In sum, sentiment has reached optimistic extremes and is reversing, suggesting that investors are becoming less optimistic. We are more interested in adding to our allocation when others are fearful. Consumer confidence (i.e. confidence in the economic outlook) remains high—which is typically a plus for stocks and a negative for bonds. We are not convinced that an increase in rates in the next few months will be a negative for the market, but it may cause investors to "sell the news." That would provide us with greater confidence to increase our participation in the equity market.

Have a wonderful week,

Neil Leeson
Day Hagan Investment Committee Consultant
Day Hagan Asset Management

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