Day Hagan Smart Sector® with Catastrophic Stop Strategy Update October 2024
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Day Hagan Smart Sector® with Catastrophic Stop Strategy Update October 2024 (pdf)
Catastrophic Stop Update
The Catastrophic Stop model combines time-tested, objective indicators designed to identify high-risk periods for the equity market. The model (Figure 1) improved toward the end of September and entered October with a fully invested equity allocation recommendation.
Figure 1: Catastrophic Stop Model vs. S&P 500 Total Return Index
The model’s increase was due to the Short-Term Trend, U.S. Stock/Bond Relative Strength, High Yield OAS, and Baltic Dry Index Factors reversing to positive levels.
Figure 2: The Short-term Trend Factor continues to oscillate around neutral levels. A decisive move in either direction would quickly be reflected in the overall model.
Figure 3: The U.S. Stock/Bond Relative Strength Factor is back on a buy signal.
Figure 4: High-yield OAS reversed to bullish levels. This indicates that the financial markets are behaving relatively normally.
Figure 5: The Baltic Dry Index Factor is also now positive (chart above).
Entering September, our investment models continue to convey a cautiously optimistic collective outlook for global equity markets. For instance, the Global Recession Probability Model now assigns a 57.28% probability of a broad-based significant global slowdown. Above 70, the probability jumps to 87.83%. The model is based on the Composite Leading Indicators for 35 countries and includes measures of money supply, yield curve, building permits, consumer and business sentiment, share prices, and manufacturing.
Figure 6: The Global Recession Probability Model crossed into the neutral zone from bullish. A move above 70 would denote “High Recession Risk.”
The Federal Reserve cut the fed funds rate by a substantial 50 basis points to 4.75%-5% in September, marking the first reduction since March 2020. The FOMC also released new economic forecasts, projecting a total of 100 basis points of easing by year-end. These forecasts indicate the possibility of two more 25-basis-point cuts in 2024 and additional cuts in 2025 and 2026. In response, the dollar fell to lows last seen in July 2023, following indications of a cooling economy and expectations of further rate cuts.
Key economic data revealed a core PCE inflation increase of 0.1% in August, below the 0.2% forecast, with an annualized increase of 2.7%. Additionally, GDP growth was confirmed at 3% for Q2, and durable goods orders defied expectations by remaining flat in August. The ISM Manufacturing PMI increased to 47.2 in August 2024, while the S&P Global US Services PMI eased to 55.4 in September 2024. U.S. consumer sentiment reached a five-month high as borrowing costs eased, supporting hopes for a continued cooling of inflation towards the Fed’s 2% target in 2024. Despite positive indicators in the service sector, business confidence weakened due to growing concerns over the economic outlook and future demand. From a quantitative indicator perspective, measures of momentum, mean reversion, breadth, volatility, ETF inflows, sentiment, relative forward earnings expectations, and business credit conditions remain supportive. A relatively weaker U.S. dollar and manufacturing PMI trends are headwinds. The net result supports the view that the uptrend is intact—especially with many U.S. equity markets and sectors near all-time highs.
Given the FOMC rate cut decision, we thought it prudent to feature the “Return Decomposition” charts below again. Recall that when reviewing the last 17 "First Rate Cuts" through the lens of earnings growth and multiple valuations, we noted that multiples have tended to expand (green line) while earnings growth was mixed, if not subdued (red line). The net result, historically, was an uptrend in stocks (blue line). But, with multiples already at the high end of the historical range, multiple expansion may not be able to save the day. It’s up to earnings. Notice that the S&P 500 returns are very negative for 2001 and 2007. The point is that if the Fed is cutting into a recession, the cuts may not be enough to provide a useful “Powell Put.”
While inflation remains slightly above central bank targets, which may delay interest rate cuts and keep borrowing costs high, the economic growth outlook remains positive, albeit slowing down. This supports credit markets and reduces the risk of defaults, supporting lending for businesses and consumers.
Figure 7: All first rate cuts since 1954. The “average” suggests a positive tilt. However, it’s not a perfect indicator.
Figure 8: The observations around two “first rate cuts” before recessions showed EPS getting crushed but P/Es expanding significantly. Again, we don’t see this scenario currently in play or likely. Nonetheless, if our economic indicators shift radically negatively, we will adjust accordingly.
Figure 9: The Earnings Model is neutral. Historically, earnings have grown when the model has been in this zone. Note: The model includes diverse measures of Industrial Production, yield curves, PMIs, credit spreads, earnings momentum, and estimate revisions. If the model declines below 40%, it will indicate that earnings expectations need to be recalibrated lower.
Sector Outlook
Sector
Consumer Discretionary
Consumer Staples
Communication Services
Energy
Financials
Health Care
Industrials
Information Technology
Materials
Real Estate
Utilities
Outlook (relative to benchmark weighting)
Overweight
Neutral
Neutral
Neutral
Neutral
Neutral
Neutral
Neutral
Underweight
Neutral
Neutral
Sector Commentary
Sector Review
Consumer Discretionary: The composite model improved with October’s update. Measures of trend, momentum, positive earnings surprises, and a reversal from short-term oversold conditions turned positive during the month. In response, we added exposure and are overweight.
Figure 10: Earnings surprises reversed from negative levels and are now more supportive.
Consumer Staples: The composite model declined this month, with overbought/oversold and breadth measures turning negative. This is in addition to negative readings based on prevailing credit conditions, food sales growth, relative short interest levels, and decelerating food inflation (pricing power). We modestly reduced exposure and remained neutral.
Figure 11: Relative breadth for the Consumer Staples sector indicates broader-based relative weakness.
Communication Services: The composite model was unchanged, with an earnings revision breadth indicator turning positive and a longer-term momentum indicator turning negative. Internal measures of trend, overbought/oversold, breadth, and volatility are negative. From an external model perspective, relative valuations are high (based on earnings yields), sales growth trends are stalling, and the internet sales versus retail sales growth rate has slowed (though still advancing). We remain neutral.
Figure 12: Relative sales growth is decelerating. Historically, this has been a headwind for the Communication Services sector.
Energy: The composite model was unchanged with the latest update and remained in the neutral zone. Momentum, overbought/oversold, and volatility measures are negative, but long-term breadth and trend indicators are supportive. Sentiment is in the middle of a 10-year range but directionally illustrates a buildup of pessimism. Should sentiment start to reverse from excessively pessimistic levels, indicating newfound and budding optimism, we would look to add exposure.
Figure 13: The Energy sector’s sentiment measure is in the process of reversing from levels denoting optimism. Once the indicator bottoms (showing extreme pessimism) and reverses, it has historically been an opportune time to add exposure.
Financials: The composite model improved slightly due to a valuation indicator based on earnings shifting from negative to neutral. Measures calling the Citi G20 Economic Surprise Index, U.S. dollar, option-adjusted spreads, and bank loan growth are negative. Conversely, the yield curve (10-year minus 2-year) is positive, and business credit conditions remain healthy. The net result is a continuation of our neutral allocation.
Figure 14: The Financials sector is heading toward oversold levels. A buy signal is generated when the 21-day smoothing declines below the lower bracket and reverses back above.
Health Care: The composite model declined this month, and we have reduced exposure to a neutral allocation. The decline was primarily due to several technical indicators turning negative, including short-term trend, momentum, and relative downside volatility. Earnings revision breadth also reversed lower, joining the negative messages from measures of declining health care new construction and health care personal expenditures.
Figure 15: It was a nice run, but the Healthcare sector’s momentum indicator is now rolling over from an overbought extreme.
Industrials: The composite model improved but remained in the neutral zone. Measures calling crude oil perpetual futures price trends and U.S. Industrial Production turned positive. These changes were partially offset by a valuation indicator based on cash flow yield turning negative and an increase in the sector’s relative volatility. At this point, measures of momentum and trend are holding up. We remain neutral.
Figure 16: Relative price momentum is now approaching overbought levels.
Information Technology: The composite model has improved, but the indicators remain mixed, with the overall level squarely in the neutral zone. Measures of momentum, net new highs, long-term breadth, and sales growth are negative. Bullish supports are based on reduced market-based inflation expectations and a relatively high short-interest ratio (indicating pessimistic conditions that could reverse). We remain with a high-neutral allocation.
Figure 17: Relative breadth is still in a downtrend. However, the indicator is approaching levels where significant reversals have started to form.
Materials: The composite model increased but remains at bearish levels. The increase was due to a short-term deviation from trend indicator, which shows the recent pullback may be overextended. Indicators calling trend, overbought/oversold, volatility, silver and gold futures, natural gas futures, and valuations based on earnings and sales are negative. The few bright spots include better performance from emerging markets (which have high commodity exposure) and rising copper prices (good for materials, bad for inflation hawks). The net result is an underweight allocation.
Figure 18: Emerging Market strength has historically been bullish for the Materials sector. However, the weight of the evidence still leans negative. If our technical indicators begin to show signs of renewed strength, we will reallocate accordingly.
Real Estate: The composite model increased to neutral levels, and we have increased exposure accordingly. The technical composite shows that the sector is primed for mean reversion as breadth indicators have started to improve. The technical improvement is supported by better homebuilder industry performance, industrial production for construction supplies picking up, positive business credit conditions, and the MBA Purchase Index showing better strength since August. Negative indicators include weak relative price trends, unemployment edging higher, and the recent backup in the 30-year Treasury yield.
Figure 19: Based on the Citi Economic Surprise Index, economic releases over the past three months have just about met investor expectations. If the indicator moves above 0, it would indicate that investors have underestimated economic strength, which has historically been a constructive condition for the Real Estate sector.
Utilities: This month’s update leaves the composite model unchanged. Both the internal and external composites are neutral. Bullish indicators include price trend, momentum, relative valuation to bonds, and the copper/gold ratio. Negative indicators include relative breadth (on a 50-day basis), some overbought conditions, and the yield on the Investment Grade Utilities sector declining and being less attractive relative to bonds. We remain neutral.
Figure 20: The yield on Investment-Grade Utilities has been declining since its peak in 2023. While still relatively high, historically, this trend is currently a headwind.
Our goal is to stay on the right side of the prevailing trend, introducing risk management when conditions deteriorate. Currently, the uptrend remains intact. As has been the case for all of 2024, the broader-based composite models calling U.S. economic growth, international economic growth, inflation trends, liquidity, and equity demand remain constructive. The Catastrophic Stop model is positive, and we are aligned with the message. If our models shift to bearish levels, we will raise cash.
This strategy uses measures of price, valuation, economic trends, monetary liquidity, and market sentiment to make objective, unemotional, rational decisions about how much capital to place at risk and where to place that capital.
For more information, please contact us at:
Day Hagan Asset Management
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Sarasota, FL 34236
Toll Free: (800) 594-7930
Office Phone: (941) 330-1702
Website: https://dayhagan.com or https://dhfunds.com
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Day Hagan/Ned Davis Research
Smart Sector® With Catastrophic Stop ETF
Symbol: SSUS
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