DAY HAGAN RESEARCH UPDATE
SIMPLE INDICATORS CAN HELP PRESERVE CAPITAL
A PICTURE IS WORTH A THOUSAND WORDS
Technical and momentum indicators may serve you well in the coming weeks.
May 31, 2016
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ETF CHARTS WORTH WATCHING
Technical analysis—in its simplest form, “chart reading”—is more art than science and is often in the eye of the beholder. While many investors will dismiss chart patterns, those patterns become invaluable as a sentiment measure if the broader crowd is following them. Can you guess what pattern has been splashed all over the financial press of late and the crowd has been watching? The dreaded head and shoulder top!
Below is a chart of the S&P 500 index illustrating the pattern that so many investors, amateur and professional, have been watching over the past several weeks. Technicians typically consider this a topping pattern. All eyes have been on the “neckline.” A break of the neckline suggests that the market will pull back in similar magnitude of the gain from the neckline to the top of the head (a pessimistic view). But when the market failed to significantly break the neckline, all eyes turned to the right shoulder. A break above this high would point to a market that was going higher (an optimistic view). Whether or not you believe in this analysis, this pattern attracted the attention of some well-known investors/traders last week. Famed technician Tom McClellan took a more optimistic position on the pattern. He pointed out last week in a twitter blog that in two recent cases (2009 and 2010), the head and shoulders led to an upside bullish continuation pattern. While I won’t take a position on the validity of this pattern, I do think it is a great illustration of how crowd sentiment can switch in a matter of days.
While chart patterns may be useful in identifying investor sentiment, at Day Hagan we are more focused on time-tested indicators that can help guide our investments. When many people hear the term technical analysis, they often think of chart readers. This form of analysis can be very useful and is part of our process, but historical indicators, which increase our odds of being correct, are the foundation of our process.
We have built technical models on hundreds of ETFs. These composite models are comprised of indicators that have historically proven to increase our odds of success. Our indicators are used to identify overbought/oversold and trend direction over multiple timeframes. While the signals generated from our models are important, the direction and level of our indicators and composites are just as important.
Below is a chart of our ETF Investment model, which is comprised of 240 indicators taken from 314 ETF models. This composite model generated a new buy signal on the market when the composite model indicators rose above 20 (bottom clip below). However, our enthusiasm for the market has been tempered given the current level and direction of the model. While the current direction turned up last week, the composite model has oscillated in a fairly narrow band over the past few months. We would like to see this composite model steadily improve from here and break above the current range. Nonetheless, the weight of the evidence is bullish and so is our current outlook.
In addition to composite technical indicators we like to monitor investor buying pressure versus selling pressure historically. As shown on the chart below, our buying pressure measure for SPY, a proxy for the U.S. large-cap market, has steadily been improving and has not reached extreme levels. This indicator suggests that buying demand is greater than selling demand. Investing can be equated to supply and demand and the scarcity problem in economics. Scarcity is a basic economic condition where there is a gap between limited—that is, scarce—resources and theoretically limitless wants. For stocks more simply put, there are more willing buyers than willing sellers, and vice versa.
The bullish reading on our composite model, coupled with increasing buying pressure, supports a bullish outlook on equities. Further improvement on both measures would warrant more aggressive allocation to equities.
ETFS TO WATCH: GOLD MINERS, BANKS, SMALL CAPS, MATERIALS, DOLLAR, OIL
Gold and gold miners ETFs have been some of the top performers on the year; however, composite models and indicators have deteriorated significantly. Below is a chart measuring how overbought/oversold the gold miners fund is based on momentum and historical z-score levels. As shown, GDX reached over 2.5 standard deviations on the one-year measure, a clear sign that the fund was overbought. And the shorter-term measure (three months, third clip) was at +5 deviations above the norm! Keep in mind that while the extreme levels are important in identifying funds that are overbought or oversold, direction is very important. Funds can remain overbought and profitable beyond statistical extremes (“the market can remain irrational longer than you can remain solvent”). The key is to watch for a reversal in the z-score measures. When the three-month measure broke below its fifty-day average (blue dashed line) it would have been prudent to reduce any long exposure to GDX. And consider being completely out of the sector when the one-year z-score crossed below its fifty-day.
Financial ETFs and bank funds in particular have been on a tear lately, fueled by the notion that an increase in interest rates by the Fed will improve bank and financial firm profits. Fundamental analysts may want to argue the efficacy of this reasoning, but composite indicators suggest that the crowd loves this sector of the market. For me, this is a good example of investing based on how the markets are acting versus how they should be acting. I am highly skeptical that a 25-basis-point increase will make a big difference to the bottom line for some of these institutions, but I have to put that aside if I want to stay in harmony with the tape.
Below is our buying pressure chart for KRE, one of the regional bank ETFs. This indicator is moving in the right direction, illustrating that there is more demand to buy than there are owners willing to sell. However, our trend model (below) remains stubbornly bearish, suggesting only small positions until we get stronger trend confirmation.
The Materials sector, as measured by XLB, has had a strong move off of its January lows. Our trend model (top chart below) gave a timely buy signal near the lows and continues to improve. On a shorter-term (three-month z-score) basis we have started to reverse from overbought levels, breaking below the 50-day average. However, our longer-term measure (one-year z-score) suggests that the fund is neither overbought nor oversold. As long as the trend model remains positive, the direction is up and longer-term OBOS is neutral, investors can add to positions on pullbacks in Materials sector ETFs.
Our trend composite for small caps (IWM) generated a new buy signal last week (bottom chart). After a brief pullback, this composite turned positive as small caps started to outperform their larger-cap brethren (top chart, second clip). Like Financials, this could have something to do with the expectations for higher interest rates and a stronger U.S. dollar, which typically helps domestic-oriented companies over international large caps. Nonetheless, the trend in small caps has improved along with an increase in buying pressure and a lack of significant OBOS conditions.
In past blogs I have written about the U.S. dollar. I think dollar and currency charts may be some of the most important tools investors should monitor over the coming months. Further dollar strength could have a significant impact on company profits, international investments and real rates of return. As shown below, UUP, the bullish dollar fund, has started to strengthen from oversold extremes. There are pluses and minuses to a stronger dollar, but strength would push money into those ETFs that have historically been most sensitive to positive movements in the dollar: Treasuries, muni bonds, corporate bonds, pharmaceuticals, biotechnology, retail, preferred stock, livestock and precious metals.
The last chart I want to show is for a crude oil proxy fund, USO. As shown, we have reached extreme overbought levels on a shorter-term basis. This warrants caution for those holding crude oil-related funds or those funds that are highly sensitive to movements in crude. While the overall longer-term trend remains positive, based on the three-month z-score, crude has gone too far too fast. Nonetheless, because the longer-term trend remains positive and crude isn’t overbought longer-term, investors may want to consider small positions on pullbacks large enough to resolve the short-term overbought conditions.
Have a wonderful week,
Day Hagan Asset Management Investment Committee
— Written 05-31-2016
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