foxex: Sentiment Indicators Look More Bearish

Chart Advisor | Focus on the Price

Monday, June 03, 2019

1. Manufacturers are signaling more weakness

2. Stocks attempt to close at breakeven

3. Risk indicators continue to worsen

Major Moves

Today is the first business day of the month of June which is the same day my favorite economic indicator (the ISM's PMI,) is released each month. The Institute for Supply Management's PMI or Purchasing Managers Index is a diffusion index of manufacturing activity in the US based on the responses of supply managers within the private sector.

The PMI report is important because it captures sentiment among supply managers who are at the very front of the supply chain. In my experience, the index is a good leading indicator because rather than counting production levels, it asks supply managers to indicate whether activity in several key areas are "increasing, falling, or unchanged." Questions like that do a better job of capturing what manufacturers think about the future; other questions end up reporting how the manufacturers have performed in the past.

As a diffusion index, the PMI report adds the percentage of "increasing" and half of the percentage of "unchanged" responses. A total reading above 50% is considered a growing economy, while a reading below 50% usually accompanies a shrinking economy.

As I often mention in the Chart Advisor, we don't really care about the number that is reported but what direction that number is heading. In other words, even though the PMI report was above 50% today, the direction it is trending is profoundly negative.

The actual PMI report came in at 52.1% this morning, that was off from its multi-year high of 61.3% in September 2018. As you can see in the following chart, a declining PMI report has a mixed record of leading market volatility like it did in 2015 or just accompanying market volatility, which is what it did with the bear markets of 2011 and 2008.

There are three things that concern me about the report this month. First, the PMI trend has continued to be negative despite a recovery in the price of the S&P 500. Second, the "best" performing category of survey responses was increasing prices (+3.2%) and third, the "worst" performing category was order backlogs that contracted -6.7%.

I continue to be reluctant to suggest that the end of the bull market is near, but from a short-term perspective, evidence continues to build that investors should be very cautious about how they are managing risk. A focus on diversification, hedging, and solid fundamentals will likely pay "dividends" for investors while economic fundamentals like the PMI report are so shaky.

S&P 500

I made the point last week that a completed head and shoulders pattern very rarely leads to a drop of more than 5% of a stock-index or individual stock. While this has been true over the testing period, I have analyzed from 2001-2019, there is an important caveat about that data. Of the head and shoulders patterns that preceded a large drop, the subsequent move was abnormally large.

For example, a head and shoulders pattern kicked off the 2011 bear market, the biggest market decline in 2012, and the 23% decline in small-cap stocks in late 2015.

The point is, although the historical odds still favor a short-term recovery, like the ISM report, the status of the current head and shoulders pattern should urge some caution. For example, a classic strategy among portfolio managers in a situation like this is to use put options on a stock index to "insure" their portfolio against losses. Like actual insurance, this is an expensive strategy but very effective.

Read more:

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Risk Indicators - Look out for dividend ex-dates

From a risk indicator perspective, things have improved a bit today as the market's decline paused. However, there is an important clarification to make this Monday if you have been following high yield bond ETFs as a leading indicator.

I recommend watching high yield bond ETFs or indexes because they will often warn of a downturn in the stock market before it takes place. We unfortunately didn't get much of a warning for the most recent decline, but its still a good place to pay attention.

However, today is an exception to the rule about high yield bond ETFs because today is the day most of them are ex-dividend. That should lead to a drop in the share price by the dividend amount. In the case of the iShares High Yield Corporate bond ETF (HYG) the dividend is $0.38 per share and the shares are down today even though we would have expected the price to mirror the major stock indexes and get closer to breakeven.

You can figure out where the price of HYG should have been today by adding the dividend back to the share price which makes it look much more like the neutral performance of the Dow Jones Industrial Average today. I wish this phenomenon had predictive power for the short-term, but this is just one of those weird things in the market that can lead to confusion unless you know what to look for.

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Bottom Line - Risk is a spectrum not a coin flip

Over the last three weeks, I have worried a little that I am coming off as bearish in the Chart Advisor. In the decades I have been working with individual investors, I know most of you already have a bit of a skeptical bearish bias anyway (which is normal) so I am sensitive to stocking undue worry.

The analogy I often use in circumstances like this is to imagine that your portfolio has a dial for how much risk you want to tolerate rather than just an on-off switch. The dial should have been turned up to "11" in 2016-2017 when the underlying fundamentals were trending in positive directions, but right now the level should be somewhere closer to the middle. As I mentioned previously, this is a good time to think about how diversified a bullish portfolio is and how risk management strategies could be used to provide a little extra short-term protection.

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