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The Market Pulse model ended the first half of 2019 reflecting broad market breadth amidst stronger industry price trends and sitting firmly in the full equity allocation range.
The model’s last allocation change on March 25, 2019 saw its equity allocation increase from 40% to 100%. Since then, market breadth as represented by the model’s Composite Score has improved substantially, from hovering below 60 to reaching 72.71 by the end of June. This is significant because when the score is above 70, the equity allocation in the model is always 100%, regardless of its direction. In a way, this is how the model gives the market the benefit of the doubt, as the market tends to have an upward bias over long-term cycles. Only when the Composite Score falls below 70 and is also lower than its score 42 days ago does the model start to scale out of equities and into cash. As of month-end June, the Composite Score direction was positive.
Source: Ned Davis Research. Data as of June 28, 2019
The strength of industry price trends has improved substantially. Of the 24 industry groups, 22 now sport a trend score of 50 or greater, and 17 hold scores over 70.
Source: Ned Davis Research. Data as of June 28, 2019
On January 15, 2019, the Market Pulse moved to a conservative position of 40% equities, stemming from weakness experienced in the fourth quarter of 2018. While not fully allocated, having some equity exposure allowed the model to participate in the strong rebound to start the year. It then moved to a 100% equity allocation on March 25, 2019. The S&P 500 and the model each gained 5.59% between March 25, 2019 and June 28, 2019. Year-to-date the S&P 500 has returned 18.54% and the model has returned 12%.
The industry group contributing most to the model’s returns since the March allocation change was Software & Services, driven by the likes of Microsoft, Visa and Mastercard. Software & Services is also the largest industry group in the model, with an average weight of 11.82% over the analysis period. Banks and Diversified Financials, each nearly half the weight of Software & Services, were the next top industry groups contributing positively to returns. No other industry group was close to Software & Services from a return contribution standpoint given its average weight and returns. The only industry that detracted from returns since the March allocation change was Energy, albeit a nominal amount.
Year-to-date the story is much the same, with Software & Services propelling the S&P 500 higher. Its weight in the index has grown from 10.95% at year-end 2018 to 12.10% as of month-end June, a historical high for the industry group. Other top industry group contributors were Media & Entertainment, driven by Facebook, Netflix and Walt Disney, and Capital Goods, led by Honeywell International, General Electric and Boeing.
Much of the S&P 500’s first half returns came early in the year. The index was up 13.65% by the end of the first quarter and 18.25% by month-end April. Trade war fears buffeted the market in May, only to recover and reach new highs in June. Since 1971, there have been only six other years with first half returns better than 2019. Three of those ended the full year lower, but still positive. The most dramatic turn was in 1987, which saw a fall of over 17% in the second half after returning over 27% in the first half. There is no guarantee, of course, that the same will happen this year or how investors will fare.
Taking a risk-managed approach to future equity allocations may be the prudent call. On top of what has become the longest bull market in history, risks remain. The ongoing trade war, softening global growth, lower corporate earnings, slowing corporate buybacks and soaring public debt are among the concerns often cited. There is plenty to navigate. Maybe that’s accomplished with a trusted stock picker or simply by following a rules-based guided allocation approach such as the Market Pulse model provides.
The Ned Davis Research CMG US Large Cap Long/Flat Index’s model (i.e., Market Pulse) measures the overall health of the market through an evaluation of market breadth. In this case, market breadth refers to advancing and declining price trends and countertrends at the GICS®1 industry group level. The model computes a robust moving average score daily to capture multi-industry and multi-term trend and countertrend measures to gauge overall market health. It then calculates the score’s directional trend to see if it is improving or declining. Collectively, the score and its directional trend determine the equity allocation of either 100%, 80%, 40% or 0%. At 0%, the allocation would be entirely to cash.2
There are a few key reasons why measuring market breadth provides sound trend analysis for guiding equity allocations. Steve Blumenthal of CMG Capital Management Group, Inc., the Index’s co-developer, wrote a whitepaper, Risk Management for all Markets, detailing this tactical approach. Historically, market breadth has typically weakened before top-line prices have at major market peaks, and breadth thrusts3 often occur just before major bull market recoveries. Furthermore, the S&P 500 is considered a very efficient market, meaning the underlying securities’ fundamentals and macro environmental factors tend to be priced in almost immediately.
Important Definitions and Disclosures
1Global Industry Classification Standard (GICS®) is a widely accepted equity securities classification system developed by Morgan Stanley Capital International (MSCI) and Standard & Poor’s.
2Allocations to equities (long) represented by the S&P 500 Index. Allocations to cash (flat) represented by the Solactive 13-week U.S. T-bill Index.
3Source: Ned Davis Research. Breadth thrust is a technical indicator used to ascertain market momentum and signals the start of a potential new bull market after what may have been an oversold market.
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