Market Pulse Signal: On Call as Uncertainty Reigned in the Market
Ed Lopez, Head of ETF Product
January 15, 2019
Market Pulse Signal Update
The Market Pulse model has reduced its equity allocation from 80% to 40%. The model informs the Ned Davis Research CMG US Large Cap Long/Flat Index and produces signals that allow the Index to tactically allocate between various levels of equity and cash. This latest change was precipitated by a declining trend in the Composite Score, the model’s measure of market breadth. On January 9, the Composite Score fell below the next critical level of 60 to 59.89, and its trend remained negative. The allocation change is reflected in the Ned Davis Research CMG US Large Cap Long/Flat Index today.
The market experienced increased volatility last year as uncertainty reigned over the future prospects of an aging bull market faced with Federal Reserve rate hikes, trade tensions, and slowing global growth. In 2018, the Market Pulse model made three allocation changes in reaction to changes in market breadth, but maintained a relatively high level of equity exposure. It reduced equity exposure in April from 100% to 80%, before resuming a full 100% allocation to equities in August after a strong summer. Then in December, as the market’s decline into correction territory gained momentum, it again reduced equity exposure to 80%.
For the full year, the Ned Davis Research CMG US Large Cap Long/Flat Index ended down -4.2% while the S&P 500® Total Return Index ended down -4.4%.1 The goal of the model is to help investors avoid the very worst drawdowns, which may take years to recover from. Followers of the model ended the year essentially with the same return as the S&P 500, but still have the risk management feature working for them in the event the market deteriorates further.
The comparable, but seemingly modest, negative returns for the full year overstate what happened in the fourth quarter. From the S&P 500’s last peak on September 20, the S&P 500 finished the year down -14%. The Ned Davis Research CMG US Large Cap Long/Flat Index ended down -12.1%, exhibiting what we view as a much more meaningful difference in performance. This was driven by the model’s signal to raise cash in early December, reducing equity exposure from 100% to 80%.
2018 YTD Performance
Source: FactSet. Data as of December 31, 2018. Past performance is no guarantee of future performance. Index performance is not indicative of fund performance. Indices are not securities in which investments can be made. Index returns do not reflect a deduction for fees & expenses. See index descriptions and additional disclosures below.
For most of the year, while a few single names caused headline making whipsaws for the top line returns of the S&P 500, market breadth as measured by the Market Pulse model remained relatively stable. The model’s Composite Score hovered between 65 and 70 until October, when market breadth weakened more broadly and fell to 62.16 by year-end.
2018 Composite Score Trend
Source: Ned Davis Research. Data as of December 31, 2018.
During the first full trading week of the New Year, the market has bounced off of oversold December lows, in a breadth thrust, according to Ned Davis Research (NDR). While the model has now reduced equity exposure to 40%, the market may still retest the December lows. Such retests often happen following oversold conditions, but that may also represent part of the bottoming process that opens the pathway for future gains. According to NDR, lower or more reasonable consensus earnings estimates and avoiding a recession in the U.S. are needed.
How the Market Pulse Model Works
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®2 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.3
Equity Allocation Based on Level and Trend of Composite Score
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 thrusts4 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
1Source of all data unless otherwise noted: FactSet and Ned Davis Research. Data as of 12/31/2018.
2Global Industry Classification Standard (GICS®) is a widely accepted equity securities classification system developed by Morgan Stanley Capital International (MSCI) and Standard & Poor’s.
3Allocations 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.
4Source: 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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