Monday, September 10, 2012

Revisiting Ned Davis's Three Rules of Making Money in Stocks

The Financial Times had a short article this morning describing the contrast between the relentless rise of the stock market and the sour mood in Corporate America.

Here's what the FT wrote:

Corporate America is more pessimistic about the prospects for short-term earnings growth at any time since the start of the financial crisis as a slowing global economy weighs on demand for the goods and services of U.S. companies.

Even as the US stock market hit a four-year high, year-on-year earnings growth for the S&P 500 slowed to just 0.8 per cent in the second quarter, while the consensus forecast among analysts is for growth to turn negative in the current quarter for the first time in three years.

Typically weakening fundamentals in the middle of a broad market rise should give rise to thoughts of reducing equity exposure.

Should you be selling now?

In the past I have found strategist Ned Davis's - founder of Ned Davis Reseach (NDR) - three rules of investing helpful in asset allocation decisions, so perhaps this is a good time to review.

1. Don't fight the tape - historically it has never made sense to bet against a strongly trending market, even if an investor is uneasy with the fundamentals.  As NDR's chief global strategist Tim Hayes wrote this morning, the most of the global equity markets are in confirmed uptrends:

Following a consolidation phase that returned the market to oversold conditions, global breadth has rebounded, with expanding percentages of markets at one-year highs...And a growing majority of markets have rising 50-day and 200-day moving averages...

2. Don't fight the Fed - when monetary conditions are easy, as they certainly are today, capital markets tend to rise in price. Moreover, an overwhelming majority of market participants now expect the Fed to be "on hold" until at least 2015, according to Bloomberg:

Just six months ago, money market traders expected the Federal Reserve to raise interest rates by the end of 2013. Now, they see borrowing costs staying at record lows for about three more years as the economic outlook worsens. 

Bond market measures from overnight index swaps, which indicate no increase in the federal funds rate until mid-2015, to a 62 percent decline in a measure of volatility in government bonds signal that rates will stay near zero for longer. The gap between two- and five-year Treasury yields, which decreases when traders expect benchmark rates to remain subdued, is more than 50 percent narrower than its average since 2008.

3. Be Wary of the Crowd at Extremes - when bearish or bullish sentiment become too widespread, markets will tend to react in the opposite direction of prevailing sentiment.

This one is tricky to measure, however.  While the retail investor continues to flee domestic equity mutual funds (which could be considered bullish), Wall Street is becoming decidedly bullish, which is cause for concern.

Here's what the blog Business Insider wrote this morning:

Markets are down a hair today, but the theme of the morning is clear: 

Uber-bullishness. Everywhere.

This is the most unanimously bullish moment we can recall since the crisis began.
Note that this comes as U.S. indices are all within a hair of multi-year highs, and the NASDAQ returns to levels not seen since late 2000.

Big macro hedge funds, who have been famously flat-footed this year, are now positioned for a continued rally

So, in my opinion, while the tape and the Fed continue to warrant a full allocation to stocks, I am slightly uneasy with the pervasiveness of the Street's enthusiasm for stocks.