Summary
- Majority of monthly data trending worse.
- Long-term slowdown underway.
- Possible change in outlook from Cautious to Bearish depending on incoming data.
Introduction
Earlier this year, Cris Sheridan asked me on his podcast (see Bolin: Wide Range of Data Suggests Market Top) if my outlook on the investing environment had changed since I had written an article for Seeking Alpha the previous month. In June, I took a step back and clarified what my outlook is for the months ahead using an Allocation Model that I have built based on 17 stock, bond, real estate, and commodity indexes updated each week, though the model only changes gradually from month to month.
“Beating the Market, 3 Months at a Time” was written by Gerald and Marvin Appel and published in 2008. I share many of their philosophies such as diversification, but my focus is more on economic vs. momentum indicators. Their title is similarly appropriate for this article since I use quarterly data for my outlook.
Allocation Model
This past month, I have improved my Allocation Model by reducing the number of quarterly indicators and tracking the timing and direction of the data. I also changed the Corporate Health Indicator to use non-financial profits instead of total profits and added Economic Policy Uncertainty to the Risk Indicator.
The Model now consists of 32 indicators of which 6 contain quarterly data. These 32 indicators are composited from over 80 monthly indicators and 19 quarterly indicators. The weight of the quarterly data is about 15% which is important to point out since my outlook is time dependent. Most of the indicators use the Excel TREND function to extrapolate the last 12 months of data to the current time period if the data is not up to date. It is now early July, but I use June as the current time period for optimization.
For May, 90% of the monthly data is up to date and 10% is projected. For June, 29% of the monthly data is up to date. Only 11% of the second quarter quarterly data is up to date as of July 1st. Four of the current quarter estimates are updated often by the Atlanta Fed Nowcast for GDP, Final Sales, Exports and Investment.
After the end of each quarter, the Allocation Model is updated for the quarterly data which can affect the allocation for the past 3 months if the new data deviated much from the trend. Of the monthly data, 65% is trending worse while 42% of the quarterly data is trending worse. My six quarterly indicators are Corporate Health, Valuation, GDP, Banking, Household, and Investment.
The chart below shows a composite of the Monthly (thru June) and Quarterly (thru Q1) indicators. Visually, the quarterly data tends to be a longer leading indicator of the investment climate while the monthly data tends to fall more rapidly as a shorter term indicator. The Quarterly Composite peaked in Q4 2013 and the Monthly Composite peaked in Q3 2014. We are in a long-term slowdown.
The graph below shows the main indicator trends for the past 18 months. Most have been deteriorating. The big drop in the Eurozone is due to the Economic Policy Uncertainty (EUEPUINDXM) index over Brexit.
The next chart shows these trends compared to the past 20 years. The investment environment has deteriorated but does not appear as bad as the start of the past two recessions.
Below is the final Allocation Model I built for my own investment purposes (someone with low transactions fees, in mostly tax deferred accounts, and a few years from retirement). It says if the trends continue in June then the allocation to stocks should drop from 25% to my minimum of 15%. Based on the trends, I am already invested at my minimum stock allocation.
Validation
I like to validate the Allocation Model with actual data as follows. The Yield Curve has flattened considerably during the past six months indicating that bond investors expect slower growth.
Financial Stress and Volatility continue to increase.
Growth in Activity, Consumer Spending, Industrial Production and Business Sales continue to slow.
Leading Indicators are not recessionary but are either flat or declining.
Of the quarterly data, banks continue to tighten lending standards, corporations continue to buy back shares instead of making investments, and profits have been declining.
Listening to the Pros
The Wall Street Journal surveyed 60 economists to create the chart below of recession probabilities. JP Morgan also estimates that the probability of a recession occurring in the next 12 months as of June to be 36%, a new high for this economic cycle.
Outlook
Allocations in the Return Model are based on the calculated stage where 1 denotes an improving investment environment, 2 strong, 3 declining, and 4 worst. I reduced the number of stages from 5 to 4 since the last article (see Charles Bolin's Detailed Investment Outlook - Market Topping, Economic Data in Decline). In June, the Investing Environment (or Investment Climate as called in “Beating the Market”) went from Declining to Bearish. However as pointed out, in June only 25% of the data is up to date and the rest is based on trends. By the end of July, sufficient data should be in to confirm the change in Stage. Changes in stages reflect my outlook. My outlook is that I am considering changing from Cautious to Bearish when the quarterly data comes out at the end of July.
According to FactSet, “For Q2 2016, the estimated earnings decline is -5.3%. If the index reports a decline in earnings for Q2, it will mark the first time the index has recorded five consecutive quarters of year-over-year declines in earnings since Q3 2008 through Q3 2009.”
Disclaimer: I am not an investment adviser. I am an individual investor who developed an investment system to assist me in making better investment decisions. People should do their own research or seek the help of investment professionals.
