Day Hagan Smart Sector® with Catastrophic Stop Strategy Update September 2024
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Day Hagan Smart Sector® with Catastrophic Stop Strategy Update September 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) declined toward the end of August but entered September with a fully invested equity allocation recommendation.
Figure 1: Catastrophic Stop Model vs. S&P 500 Total Return Index. The model’s decline was due to the Short-Term Trend, U.S. Stock/Bond Relative Strength, High Yield OAS, and Baltic Dry Index Factors shifting to negative levels.
Figure 2: The Short-term Trend Factor is hovering 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 also reversed to a sell signal. The previous buy signal had been in place since November 17, 2023. When bonds evidence relative strength, it has historically been a good indication that the demand for equities is transitioning to a more risk-off or defensive posture.
Figure 4: The same holds true for our measures of credit spreads. For example, high-yield OAS could quickly reverse to bullish levels. Even though the indicator has generated a sell signal, it wouldn’t take much to reverse it. The High-yield OAS moving averages have ticked higher but are still at historically low levels. This indicates that the financial markets are behaving relatively normally. A spike higher would be concerning.
Figure 5: Economic activity has declined slightly, but real GDP growth is still positive overall. The Baltic Dry Index Factor has moved moderately lower (chart above).
During August, the U.S. dollar index hit 13-month lows as markets assessed major central banks’ monetary policies. Investors anticipated rate cuts by the Federal Reserve, with expectations of around 100bps in slashes by the central bank in their three remaining decisions this year. However, signs of robust U.S. growth, such as a rebound in durable goods orders, raised doubts about the magnitude of total rate cuts. Meanwhile, dovish signals from ECB policymakers limited the dollar index’s decline. The U.S. economy expanded 3.0% in Q2, with faster consumer spending and a narrowed trade deficit. U.S. Manufacturing PMI fell to 48, indicating a second consecutive contraction, while the Services PMI edged up to 55.2, pointing to a slight improvement. Retail sales surged 1% month-over-month in July 2024, the biggest increase since January 2023, while the CPI increased 0.2% month-over-month in July 2024. External indicators calling U.S. Manufacturing PMIs, the U.S. dollar, and investor sentiment are negative. Business credit conditions, the relative forward earnings yield, and ETF flows are positive. Technical indicators are also mixed, with trend and momentum indicators extended and Advance/Decline factors supportive. All of this supports the positive but more subdued message described by the Catastrophic Stop model.
With that in mind, 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.”
Figure 6: All first rate cuts since 1954. The “average” suggests a positive tilt. However, it’s not a perfect indicator.
Figure 7: The observations around two “first rate cuts” before recessions showed EPS getting crushed but P/Es expanding significantly. Again, we don’t see this type of scenario currently in play, or likely. Nonetheless, if our economic indicators shift radically negatively, we will adjust accordingly.
Figure 8: 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.
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)
Neutral
Neutral
Neutral
Neutral
Neutral
Overweight
Neutral
Neutral
Underweight
Neutral
Neutral
Sector Commentary
While the overall U.S. equity market was higher in August, defensive and oversold sectors led sector performance. Consumer Staples, Real Estate, Health Care, Financials, and Utilities all increased by more than 4%, while former sector leaders, including Information Technology, Communication Services, and Consumer Discretionary, returned just +1.16%, +1.23%, and -1.08%, respectively. However, it is important to note that most of the weakness in these three sectors occurred during the first five days of August (following the July 16th peak). Since the August 5th low, the Financials, Technology, Industrials, and Consumer Discretionary sectors have returned to leadership positions.
Recent economic data suggests the Federal Reserve needs to lower interest rates. The core personal consumption expenditures (PCE) price index rose by 0.2% month-over-month in July, matching market expectations. Focusing on the upcoming August jobs report, Fed Chair Jerome Powell reaffirmed the need for rate cuts due to a cooling labor market and slowing inflation. This sentiment reflects the sentiment from the last Federal Reserve meeting, where most policymakers agreed on the appropriateness of lowering the Federal funds rate.
Meanwhile, the U.S. gross domestic product (GDP) grew at an annual rate of 3.0% in the second quarter of 2024, mainly due to increased consumer spending. However, unemployment rose to 4.3% in July, the highest since October 2021, with a noticeable downward adjustment in job growth. The U.S. economy added 114K jobs in July, below expectations and reflecting a moderating labor market. Annual inflation in the U.S. slowed to 2.9% in July 2024, the lowest since March 2021.
In the manufacturing sector, the ISM Manufacturing PMI fell to 46.8 in July 2024, showing the sharpest contraction in U.S. factory activity since November 2023. The data also revealed a decrease in new orders, backlogs, and employment. On the other hand, the S&P Global U.S. Services PMI edged up to 55.2 in August 2024, with new business inflows increasing and a slight improvement in service sector activity. U.S. retail sales soared 1% month-over-month in July 2024, the biggest increase since January 2023.
Overall, the data shows a mixed economic picture, with a cooling labor market, slowing inflation, and declining factory activity. This has led to increased expectations of the Federal Reserve cutting rates to stimulate economic growth and stabilize market conditions, providing support for the equity uptrend. If our models shift more negatively, we will quickly respond.
Sector Review
Consumer Discretionary: With the September update, the overall sector model declined but remained in neutral territory. Lower interest rates are contributing to better consumer spending, and this sector is a direct beneficiary. Nevertheless, concerns around a softening job market and growing credit card balances could lead to uncertainty. Earnings growth is key, with investors expecting 2024 earnings to be up 10.8% and another 13.6% in 2025. The PEG ratio (P/E divided by earnings growth) is 1.7, and perhaps surprisingly, is equal to the S&P Value index. The top holdings, Amazon (22.2% weighting), Tesla (17.1%), and Home Depot (9.7%), have seen significant negative earnings growth revisions for their respective upcoming quarters. Technical measures, including trend, momentum, and overbought conditions, are negative. Conversely, net new highs, consumer credit conditions, interest rate trends, and relative valuations are supportive. The net result is a neutral allocation.
Figure 9: Earnings surprises are negative for consumer discretionary stocks, but we are monitoring to see if the latest improvement is marking a low. We require more evidence.
Consumer Staples: As mentioned earlier, the Staples sector looked set to break out in early August; however, the leadership was short-lived. Following the market low on August 5, the sector has delivered average returns. The Composite model is now in the high-neutral zone, supported by improving momentum, better breadth (net new highs and advances/declines), stable credit ratings, valuations, and, from a contrary perspective, growing concerns around economic activity (defensive stocks do well when investors are concerned about economic growth). Cautious credit conditions, a deceleration in food sales, low short-interest ratios, and a decrease in the pricing power for food manufacturers remain headwinds. We correctly increased exposure at the beginning of August and with the September update, remain neutral.
Figure 10: Economic weakness eventually benefits defensive areas of the market. To date, the economic backdrop is still positive and growing.
Communication Services: The Composite model is virtually unchanged from last month. The Internal composite is negative, and the External composite is neutral. Valuations and earnings revision breadth are still rated negative, while technical indicators calling trend, overbought/oversold, volatility, and deviation from trend also remain on sell signals. There are some good signs, with sector-related credit spreads still narrow relative to history, positive sales growth trends, and a short-term lift from oversold conditions. We also note that the yield curve has become less inverted. A less inverted yield curve can result from reduced recession risk, an improved economic outlook, and/or expectations of interest rate cuts by central banks—all of which would support consumer spending. Meta and Alphabet are over 42% of the sector weighting. Meta has seen quite positive earnings revision activity, while Alphabet has been more mixed. We remain neutral relative to the benchmark but are ready to add if the technical indicators show broader-based improvement.
Figure 11: Earnings revisions are also rolling over for the Communication Services sector. Nonetheless, the sector’s earnings growth expectations for 2025 is currently 15.6%.
Energy: In August 2024, energy pricing was influenced by several key factors. OPEC+ production cuts continued to impact oil prices by creating a buffer of spare capacity, adding uncertainty to the market despite fluctuations in demand. However, more recently, OPEC floated the idea of increasing production. Geopolitical tensions, including the situation in the Middle East and sanctions on Russia, contributed to price volatility due to concerns about potential disruptions to oil supplies. Efforts in Europe to diversify away from Russian gas increased global competition for liquefied natural gas, impacting natural gas and electricity prices. In the U.S., the use of the Strategic Petroleum Reserve (SPR) to manage oil prices also played a significant role, with decisions about SPR management influencing market expectations and price stability. The Composite model remains neutral, with measures of momentum, overbought/oversold, volatility, sentiment, and inventories negative. Positive supports include some breadth improvement, better valuations, and some stability in crude spot pricing. We remain with a neutral allocation.
Figure 12: The Energy sector’s relative cash flow yield is reversing from lows, a positive occurrence. Should the overall model improve, we will add to the position.
Financials: Following the strong performance in August, the Composite model has declined, reflecting the increase in risk produced by the appreciation. The External composite is now negative, with indicators pointing to a decelerating U.S. economic outlook, a weaker U.S. dollar, credit spreads for financial companies widening, bank loan growth still subdued, and valuations on the high side. The lone external positive indicator is a narrowing yield curve. Technicals for the sector are also mixed, with momentum, trend, and relative drawdown measures positive. Yet, overbought conditions and increasing volatility are negative offsets. Berkshire Hathaway and JPMorgan Chase are the two largest holdings (13.1% and 10.1%). Both registered earnings beats in their latest reported quarters, and earnings estimate revisions have been positive. Currently, the net result of the indicators is a neutral weighting.
Figure 13: Financial institutions’ investment-grade OAS are ticking higher. We’re monitoring closely for signs that credit quality is getting worse.
Health Care: The Composite remains bullish but has declined from August levels. Short-term measures of momentum and breadth have rolled over, but the Internal composite remains positive. Medical care inflation, valuations, and sector-specific credit spreads are also positive. The lone negative is health care new construction, which has been tailing off as commercial real estate works through excess inventory. Currently, the Health Care sector has the second highest expected earnings growth expectations for 2025, at 20.8% (just behind Information Technology at +21.0%). We remain overweight.
Figure 14: Breadth has improved from deeply oversold levels but is now approaching overbought levels and is showing signs of reversing. This has historically been a headwind.
Industrials: Throughout August 2024, the Industrial sector experienced steady but cautious growth due to several significant factors. Government spending from initiatives like the Inflation Reduction Act (IRA) and the Infrastructure Investment and Jobs Act (IIJA) supported infrastructure and onshoring activities, driving growth in construction and manufacturing. The prevailing high interest rates impacted the sector, influencing capital expenditures and investment activities. Supply chain challenges persisted, leading to delays and increased costs in material sourcing. August seasonal trends, typical for slower industrial activity, also affected the sector’s performance. The Composite model remained neutral. The Internal (technical) composite is bullish, and the External (operating environment) composite is negative. Measures of momentum, trend, overbought/oversold, and volatility are supportive. Valuations, oil price trends, commodity prices, and the U.S. dollar are headwinds. The net result is a neutral exposure relative to the benchmark.
Figure 15: Relative price momentum is now approaching overbought levels.
Information Technology: The Composite model declined slightly with this month’s update to low-neutral levels. Indicators evaluating net new highs, relative momentum, breadth, valuations, short interest, and Emerging Asia correlations are negative. Conversely, measures of overbought/oversold conditions have not yet registered overbought reversals, and earnings revisions remain generally positive.
Last month, we noted that the top 3 holdings had shifted back to Microsoft (21.5% of the ETF’s holdings), Nvidia (19.9%), and Apple (down to just 4.89%) due to Capping requirements in the XLK ETF (to learn more about Capping, please give us a call and we’ll send you our report). Capping continues to be an important factor, with the year-to-date GICS Information Technology sector return +26.53%, while the XLK ETF return is just 14.35%. Note that on July 25, in response to the information technology sector model having moderated to a more neutral level, we took approximately 4% of combined exposure off the table by booking profits from our XLK (the Technology Select Sector SPDR Fund) and MAGS (Magnificent Seven ETF) positions. Prior to July, we were heavily invested in the sector due to positive internal and external indicators. The number of new highs was increasing, and other breadth indicators were close to signaling a buy. We suggested that it might be time for the troops to support the generals. Last month, we viewed the sector as overbought. However, at that point, a clear reversal had not happened, though a few of our short-term indicators were showing signs of exhaustion. Our model indicated that there was less support for the bullish trend, so being significantly overweight was no longer justified. We noted that the positioning for upside in the MAGS was overextended, as investors were fully committed to these stocks. With investors still quite optimistic, companies needed strong earnings performance to meet expectations, and it is becoming less certain that earnings growth would materialize. NVDA is now trading at 23.3 times forward sales (not earnings), down from 25.3 times on July 1. Microsoft is 11.1 times (compared to 13.6x on July 1) and Apple is 8.9 times (compared to 8.4x on July 1). We are neutral.
Figure 16: The Information Technology sector OBOS indicator is back into overbought territory. A reversal below the lower bracket would generate a sell signal.
Materials: Fluctuations in commodity prices, largely driven by global demand shifts, particularly from major economies like China and the U.S., heavily impacted the sector. Slower-than-expected global economic growth, economic uncertainty in Europe and Asia, and cautious spending on infrastructure and construction projects also affected the demand for materials. Additionally, increasing regulatory pressure on environmental sustainability and currency fluctuations due to the strength of the U.S. dollar impacted companies within the sector. Notable M&A activity was observed as companies aimed to consolidate and expand their market presence, driven by the need to achieve economies of scale and improve supply chain efficiencies. Both the Internal and External Composites are negative. We are underweight.
Figure 17: The Materials sector price is reversing from a short-lived overbought condition.
Real Estate: The Composite model is unchanged heading into September. The real estate sector encountered significant challenges in August 2024 amid a persistently high interest rate environment. Commercial properties, especially office and retail spaces, experienced reduced demand due to the growing popularity of remote work and e-commerce. Although the residential real estate segment demonstrated resilience, elevated mortgage rates hindered market activity. Furthermore, inflationary pressures in construction materials and labor costs tightened profit margins for real estate developers and property management firms. Additionally, broader economic uncertainties, such as geopolitical tensions and market fluctuations, contributed to a sense of caution among investors, leading to a mixed performance across different segments of the market. The Internal composite is bearish, and the External composite is bullish. Measures of trend, breadth, and deviation from trend are negative, though with prices at current levels, there may be a mean reversion opportunity in the near future. We’re monitoring the other technical indicators for confirmation, which have not yet materialized. Better housing numbers over the past few weeks have been encouraging. The Homebuilders sub-industry index remains on a buy, and lower interest rates and the MBA Purchase Index are supportive. We also note that the Industrial Production trend for construction supplies recently turned positive. There are still lots of problems with CRE loans, with $1 trillion coming due over the course of this year. We remain underweight but will add exposure if the models start to gain traction.
Figure 18: Business credit conditions are starting to roll over. A decline below -1 would be concerning.
Utilities: In August, the S&P 500 Utilities sector faced challenges due to continued high interest rates, renewable energy transition, and weather-related demand changes. Companies like NextEra Energy focused on expanding renewable energy projects, while Duke Energy negotiated rate increases to cover its transition costs. Meanwhile, Southern Company aimed for net-zero emissions by 2050, investing in new technologies and facing scrutiny over project costs. Weather patterns also influenced electricity demand. Altogether, these factors shaped the sector’s performance, highlighting the impact of interest rates, regulatory pressures, and the ongoing energy transition on utility companies. Notably, NextEra Energy and Southern both reported earnings that were better than expected, boosting confidence in the sector. Additionally, investors have been viewing the sector as an “ancillary beneficiary” of the AI boom. (The picks and shovels, if you will.) The Utilities Composite model improved slightly, and we have increased exposure in response. Several technical indicators (moving averages, price reversals, oversold/overbought, relative breadth) are on buy signals. We are now neutral.
Figure 19: Relative breadth (based on a 50-day measure) had reversed from oversold lows and is now in overbought territory. These types of indicators can stay overbought for longer periods. However, when they reverse and begin moving back toward oversold, it is usually a sign that the sector is under relative pressure.
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:
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Smart Sector® With Catastrophic Stop ETF
Symbol: SSUS
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