Why the Second Half of 2018 Should Be Good for Equities

Thomas Campbell, Portfolio Manager

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The stock market hasn’t really been able to get out if its own way this year, and the fixed income markets have offered little in the way of an alternative. Given all the good news about earnings and the economy, it may well be that the overhanging risk is political. Mid-term election years for a first-term president are, after all, notoriously bad for that president’s party. But history tells us it doesn’t have to be bad for the market.

It’s well known that both of the Fund Architects investment strategies – the Multi-Factor Ranking System℠ and the Multi-Factor Trading System – pursue performance in a systematic way, each with a well-defined entry and exit strategy in place. By definition, we rely on a systems-based analysis of current market conditions to get our allocations right. In other words, we’re not interested in guessing about macro events that are going to happen. That doesn’t, however, mean we can’t make observations about events that have happened. And right now, I think there’s plenty of good stuff to see out there – if you look hard enough.

MOVING SIDEWAYS

The chart below is a one-year illustration of the NASDAQ 100 showing a 200- and 50-day simple moving average drawn along with the daily close line. It’s easy enough to see that the trend is unmistakably up throughout 2017 and into 2018. There are, in fact, hardly any violations of the moving averages. But toward the end of January things change…see that on the 26th the average settled into a sideways trading pattern and, frustratingly enough, stayed there.

WORRISOME BENCHMARK ACTIVITY

The action of the NASDAQ 100 is of primary importance to us, of course, since it’s the trading vehicle of choice for the Tactical Unconstrained Growth Portfolios. But we’ve learned over time that we gain important insight into the market’s behavior by analyzing the S&P 500 at the same time. And for good reason: When people trade the S&P 500 as an index – which most passive and even active managers do – it impacts our NASDAQ 100. Not too surprising given that the five target stocks in the NASDAQ 100 – Apple, Amazon, Facebook, Microsoft, and Google – are also the five largest stocks in the S&P 500. The direction of the two indexes is very correlated even if the strength of the moves is not.

This chart above is of the S&P 500 across the sideways NASDAQ market from January. The illustration shows the same top as the NASDAQ 100 on January 26th, but with the top in March a lower high. From there, the S&P 500 reached its trading low of 2,581 on four times, but the subsequent tops were a declining series of lower highs. All of this happened, meanwhile, against a background of the NASDAQ 100 moving sideways through its own range. Worse, the two long-term moving averages were starting to converge, typically a very bearish sign.

NO HELP FROM FIXED INCOME

So, what have bonds been doing through all of this? The answer matters a lot to us since the Multi-Factor Trading System typically utilizes fixed income in sideways equity markets.

Not much as it turns out. The following illustration show chart of the S&P 500 but with the addition two new lines: the price action of long government bonds (TLT) and short-term government notes (TBF). Clearly, neither has moved in either range or direction since January 26th . As a result, our system has mostly led us to cash as a hedge against the uncertainty of any equity positions in the Tactical Unconstrained Growth Portfolio.

BREAKING OUT?

Now, let’s revisit that previous S&P 500 chart, but extend the dates through May 23rd. Based on that view, it’s not too hard to suggest that the S&P 500 began breaking out of its previous formation around May 7th. (Our signal has called for 100% equities since.) The question remains, though, whether this a real breakout or not.

At this writing, the breakout looks sustained, but sideways again. Why? I think two things are at play here – past history and current politics.

Historically, we’re told by the Stock Trader’s Almanac that when all three January indicators — Santa Claus Rally, First Five Days, and full-month January Barometer — are positive, the next eleven months and full-year market performance are significantly above average. (These three indicators were all positive for 2018, by the way.) More importantly, when the January Trifecta was positive in midterm years – like 2018 — the S&P 500’s average full-year gain was an impressive 21.1%, way ahead of the 6.7% posted for other midterm years.

Trifecta or not, midterm elections are a bottom picker’s paradise. The average top-to-bottom decline in the market during the midterm is 20.1% (worse when Democrats control, less when Republicans control). From that bottom, which generally occurs in the late summer months, the Dow has gained nearly 50% on average from the midterm low to the pre-election year high.

WHAT’S AHEAD?

In the meantime, the market still can’t seem to get out of its own way. Maybe investors are waiting for a market low later in the year. Maybe traders are already picking at the bottom against a backdrop of improving earnings, a still low-interest rate environment, and an ongoing global economic expansion. We’ll not hazard a guess. But either way, it’s reasonable to think the second half of 2018 will be better for equities than the first.


The views in this commentary are those of Fund Architects. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this commentary, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from Fund Architects or any other investment professional.  The information contained within this commentary should not be the sole determining factor for making investment decisions. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with Fund Architects. Information pertaining to Fund Architects advisory operations, services, and fees is set forth in Fund Architect current disclosure statement, a copy of which is available upon request. Fund Architects, LLC is an SEC Registered Investment Advisory Firm.

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