It’s a Market of Stocks, Not a Stock Market

It’s a market of stocks. This is important to keep in mind in a world where everyone seems to be laser focused on the main market averages. How many times over the past few weeks have we heard about the 2,000+ point plus moves in the Dow (I won’t get started on quoting the Dow in points, that’s for another time) or the double digit percentage gain or loss for the S&P 500?

Yes, it is important to have a sense of what the averages are doing, but they are just that…averages. How many times in the last 50 years has the S&P 500 actually returned its average? The real story is told under the surface, in my opinion. What are the individual stocks doing that make up those averages? 

As a true believer in a trend following methodology, one way that I can get a sense of what is happening under the surface of the market is to look at how many of the individual stocks are in long-term uptrends. To make this exercise a little simpler, I will use the 200-day moving average as a proxy for the long-term trend. From there I can easily look at what percentage of stocks in the index is currently above or below their respective 200-day moving averages. Currently this number is only 9%.

But the 9% number does not tell us all that much other than we are likely at an extremely low level. As recently as January 17th, this metric was at 83%, what does that level mean?.  It is more insightful to look at what happens when a specific line in the sand has been crossed. Using a diversified mix of ETFs we can see how an equally weighted portfolio has performed when this metric crossed a key level after an extreme. In this case we will look at what happens when we cross below 80% and cross above 20%.

The ETFs that we are using are:

  • Vanguard S&P 500 ETF (VOO)
  • Vanguard Small Cap ETF (VB) 
  • Vanguard FTSE Emerging Markets ETF (VWO)
  • Vanguard Real Estate ETF (VNQ)
  • iShares 1-3 Year Treasury Bond ETF (SHY)
  • iShares iBoxx Investment Grade Bond ETF (LQD)
  • Vanguard FTSE Developed Markets ETF (VEA)

When the percentage of stocks in the S&P 500 greater than their 200-day moving average cross below the 80% mark we can see that the average return of the portfolio -0.19% over the next 63 days (roughly one quarter) and the probability of gain is 61.54%.

Here is the path to that negative return over the course of the average 63 period after the cross.

However at the level of the individual ETFs, the returns are more dispersed. We can see that over the ensuing 63 days, it is the foreign exposure that weighs the portfolio down. Real Estate appears to serve its purpose as a defensive holding, returning 2.71% on average.

What about the going in the opposite direction? Given the current depressed level for the percentage of stocks above their respective 200-day moving averages, what happens if we cross the 20% mark? Since 2011, the equally weighted portfolio logs an average return of 6.43% over the next 63 days with a probability of gain nearing 81%.

The path to those gains is a fairly steady rise as we can see here.

Looking at the ETFs themselves, it is the small caps that lead the charge higher. Surprisingly, Real Estate is in the number two slot. The fixed income products lag on the way back up as we might expect.

Clearly we would want to take this analysis further by looking at other timeframes and also by incorporating the Chaikin Power Gauge ETF Rating, but for now, the take-away is that monitoring breadth, especially when leaving extremes, can open the door to tactical adjustments to portfolios that have the potential to enhance performance over the ensuing three months.

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