Top Of Mind...
Among our investment philosophies there are a few that I specifically mention here from time to time. One of those is the belief that stock market rallies are bullish, meaning that gains lead to more gains.
That may sound obvious, but I know for a fact it isn't to most people. I know this because of how often I hear people say they think the market is about to fall. Or, by the amount of attention an article attracts if it involves predicting that the market will crash. The problem is, most doomsday articles are ripe with bold claims about why the market is going to plunge but void of meaningful analysis to explain why. These predictions usually involve the phrase "because we are due for a crash". Perhaps it is because we have an innate feeling that what-goes-up-must-come-down, especially for those who invested in 2002 and 2008. Those memories remain fresh.
I most recently turned bullish on the stock market in the summer of 2016. The market had just finished a pretty volatile 18-month stretch where it essentially went nowhere. It appeared to me then -- based on my analysis -- that the market was primed to rally. So I was not surprised when it did, even amidst the turmoil of the 2016 presidential election and the uncertainty that a lot of people had about the future direction of the stock market.
Today, however, I am starting to feel surprised.
U.S. stocks just wrapped up another winning week. The S&P 500 has now risen in 17 of the past 21 weeks dating back to this past August. A staggering feat. Excluding dividends, the S&P is up roughly +14% in that time. As surprising as that might be, the more surprising thing is how stretched one of the key statistical indicators is that helps guide our analysis: Relative Strength.
The Relative Strength Index, or RSI, is a statistic we use to measure market momentum. We look at it in tandem with the price of any investment we buy or sell. For instance, if the price of the Technology sector fund (XLK) is rising and the RSI reading for the Tech sector fund is also rising, that would imply momentum is strong and the price will continue rising. Flip that around and the same would be true if both the price and RSI were falling. We would presume that the price will fall further.
Right now Relative Strength is officially off the charts. RSI typically floats between a value of 30.0 and 70.0. The higher the reading the better, but if it gets too high it often indicates that the stock market is overheated. Most investors view 70.0 as that threshold. Right now the RSI for the S&P 500 index is at a staggering 87.0. Not only is it above the upper threshold but it is the highest RSI reading for the U.S. stock market since 1959!
Take a look at how the S&P 500 has risen over the past 14 months to get to where we are today:
The RSI reading is the smaller chart plotted above the S&P 500 price chart. Notice in the upper-right corner just how far RSI is extended (3). This chart does not show it, but you would have to go back to the Eisenhower administration to see Relative Strength of this magnitude.
Ironically, I tend to view RSI readings above 70.0 as bullish. I cannot really say why, other than through my years of experience seeing investments continue to rise for a substantial period of time after their RSI levels had reached 70.0. Normally I would say this too is bullish, but this is uncharted water given that market momentum has stretched itself to a 60-year high. Truth be told, I expected some sort of pullback by now, even if it was a quick -5% blip that freaked people out before investors swooped in to buy at discounted prices.
Does this mean you should sell stocks? No. But it has made us more judicious about how we are allocating new money. We are very sector-oriented right now, meaning we are prone to buy funds tied to specific sectors we believe are strong (e.g. Tech, Industrials, Health Care) rather than buy the S&P 500 index fund as a whole.
There is one other way RSI helps inform our investment decisions -- when RSI starts to diverge, or break away, from the price. For instance, if the value of the S&P 500 is rising but its RSI is flattening or falling, we might interpret that the market is losing steam and could fall soon. An ominous turning point, if you will. The opposite is true too. If the price has been falling for some time and RSI has bottomed and is now rising, it could mean that a rally is near.
This type of RSI divergence is crucial, as it was here back in the summer of 2011:
Notice how RSI (2) started falling, yet the price of the S&P index (1) stayed mostly flat. Eventually the S&P took a -15% dive in the matter of a few weeks (3). This is a great example of how RSI proved to be a very good leading indicator. Market momentum faded and eventually stock prices succumbed to that dwindling demand.
I really like the above chart because it illustrates what a more "normal" market correction looks like. Most investors only think about 2008 and the -40% decline that occurred during the subprime mortgage crisis. But if you look at the 100-year history of the stock market you will see that -40% drops are not normal. What is more normal are -10% drops or -15% drops, such as what occurred in 2011.
As scientific as we try to make our investment process, the way we use RSI and stock price together is as much an art as it is a science. Most often it helps confirm that we should continue holding an investment more than it tells us when to sell, since the stock market has a bias to go up in the long run.
I am happy to answer any questions you might have. I hope you found this informative and not too technical.
In The Market...
The S&P 500 gained +1.7% this past week. Let's look at how the individual sectors performed:
Growth stocks like Industrials and Consumer Discretionary continued to be strong out of the gates in 2018. Dividend-paying areas of the market like Utilities or quality bonds were down again. The rabid thirst for growth stocks has come at the expense of investors selling the more conservative areas of the market, like REITs, Utilities and Treasury bonds.
That tide might be about to swing though, if only for a short time. Most client accounts own Utilities. I have been displeased with the recent losses within that sector. However, I do think Utilities will rebound soon. Whether that means we sell and pivot to different sector remains to be seen.
In Our Portfolios...
A few housekeeping items pertaining to tax documents, review meetings and Scottrade.
Tax Forms -- TD Ameritrade will make tax forms available on the following dates:
- Form 1099 (Brokerage Accounts): This contains capital gains/losses as well as dividend income for taxable accounts. This form will be available sometime between Jan. 19th and Feb. 14th.
- Form 1099-R (IRA Accounts): This shows what IRA withdrawals you made, if any. This form will be available on Jan. 22nd.
You can access the forms by logging into your TD Ameritrade account. I can also email them to you as well. As I mentioned last week, there are likely to be corrections to the 1099 Brokerage form. Please wait to file your taxes until you have received the final version. Corrections are typically made to the dividends figures reported.
Also, most of you will receive a 1099 from Scottrade as well, for the time we held accounts there prior to migrating to TD Ameritrade. Sorry that you will have to navigate two different tax forms, but the good news is that there will only be one tax form for 2018 come next Spring.
Video conferencing -- Whether for formal reviews or one-off conversations, we are using video conferencing more and more. It is efficient given the ability to screen-share and it eliminates the time associated with commuting to/from our office. We are certainly still able to meet face-to-face, but just want to highlight this as an alternative since it might be more conducive to your schedule.
Scottrade -- Some of you still receive random notices from Scottrade from time to time. With the exception of tax information, ignore any notices you receive.
What's New With Us?
My wife and I went to see "The Book of Morman" at the Paramount Theater this weekend. I also spent a few hours trying to get our water/ice dispenser working on our refrigerator, but was unsuccessful. The buttons on the panel all work, but no water or ice dispenses when the lever is pressed. I welcome any tips you have if you have tackled this type of thing before.
Have a great week,
Brian E Betz, CFP®