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Financial Stress Index Is Screaming, ‘Bear Market Rally’

What if investors had a way to determine the extent of “stress” in the financial system? And what if those stress levels could tell investors whether or not riskier assets (e.g., stocks, higher-yielding debt, etc.) can succeed without definitive U.S. Federal Reserve intervention? Consider the Cleveland Financial Stress Index (CFSI). The CFSI monitors the well-being of a wide range of financial markets, including credit, equity, foreign exchange, funding, real estate and securitization. According to the Cleveland Fed, a CFSI reading greater than 1.855 represents the highest threat level to the financial system. We’re sitting at 1.91. Click to enlarge Both the Asian Currency Crisis in 1998 and the eurozone Debt Crisis in 2011 wreaked havoc on the typical U.S. stock. Small company shares, mid-sized company shares as well as shares of the average large company declined 20%-30%. On the other hand, when the popular market cap-weighted Dow and S&P 500 barometers approached the 20% bear market line in those crises, the U.S. Federal Reserve promptly stepped in. In 1998, the Fed orchestrated a bailout of the infamous hedge fund, Long-Term Capital Management, and sharply cut interest rates. In 2011, the Fed helped coordinate worldwide central bank stimulus as well as introduced “Operation Twist” — selling short-dated U.S. Treasuries to buy longer-dated U.S. Treasuries for the purpose of depressing borrowing costs. What about 2008? The U.S. Federal Reserve did slash interest rates dramatically in the first quarter. What’s more, the Fed organized the bailout of Bear Stearns in March of that year, sparking a relief rally that kept the S&P 500 well above the bear market demarcation line for three more months. But it wasn’t enough. Even cutting the Fed Funds overnight lending rate to 0% by December wasn’t enough. The Fed wasn’t able to inspire confidence again until quantitative easing (QE) began in 2009. The recent rally for riskier assets here in 2016 is similar to relief rallies in the past; that is, shorter-term gains often overshadow longer-term financial distress as well as deteriorating market internals. For instance, a rising price ratio for iShares 7-10 Year Treasury (NYSEARCA: IEF ):iShares iBoxx High Yield Corporate Bond (NYSEARCA: HYG ) is indicative of a preference for risk-off investment grade credit over speculative higher yielding credit. Is there anything in the present IEF:HYG price ratio to suggest that the longer-term trend is abating? Now step back in time to the 10/2007-3/2009 bear. The IEF:HYG price ratio steadily marched higher until March of 2008. The Fed bailout of beleaguered financial firm Bear Stearns temporarily provided relief for risk assets, but the relief rally ended three months later. Once more, the IEF:HYG price ratio ascended like a mountain climbing enthusiast. History teaches us that the Fed is unlikely to ride to the rescue unless the Dow and the S&P 500 challenge bear market territory. Even then, the rescue endeavor would require sufficient firepower. These historical precedents, then, make the current relief rally particularly troubling. For the Fed to wait until the major benchmarks buckle means that the financial system may grow increasingly unstable. And by then, cutting rates back to the zero bound or twisting shorter-term maturities to purchase longer-dated ones may be insufficient. Again, the Fed’s own assessment tool places the financial system at the highest level of instability, Grade 4 “Significant Stress.” Recall that the iShares All World Ex US Index ETF (NASDAQ: ACWX ) has already depreciated 25%-plus from the top. Small caps in the Russell 2000 (NYSEARCA: IWM )? Ditto. Transportation stocks in the iShares DJ Transportation ETF (NYSEARCA: IYT )? Nearly 30% erosion. Bear market descents have occurred in virtually every stock arena. It follows that when a wide range of stock types are fading, and when a wide range of debt types of different credit quality relative to U.S. treasuries are faltering, popular benchmarks like the Dow and S&P 500 eventually follow suit. The S&P 500 SPDR Trust (NYSEARCA: SPY ) will not be a lone exception. A hold-n-hope advocate may not wish to change any aspect of his/her portfolio holdings, regardless of financial stress levels, historical probability, technical trends or fundamental overvaluation concerns. On the flip side, an investor who wishes to reduce exposure to downside risk can use a bear market rally to his/her advantage . Jettison a lower quality junk bond ETF for a higher quality investment grade corporate bond ETF like iShares Intermediate Credit (NYSEARCA: CIU ). Trade in a lower quality stock ETF for a higher quality stock ETF like iShares MSCI USA Quality Factor (NYSEARCA: QUAL ). And disregard those who boldly declare that “cash is trash.” My moderate growth and income clients have witnessed less volatility and have experienced better risk-adjusted returns with roughly 20%-30% cash/cash equivalents since last summer. (And that’s before the levee broke .) Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Best And Worst Q1’16: Utilities ETFs, Mutual Funds And Key Holdings

The Utilities sector ranks last out of the ten sectors as detailed in our Q1’16 Sector Ratings for ETFs and Mutual Funds report. Last quarter , the Utilities sector ranked fifth. It gets our Dangerous rating, which is based on aggregation of ratings of nine ETFs and 34 mutual funds in the Utilities sector. See a recap of our Q4’15 Sector Ratings here . Figure 1 ranks from best to worst eight Utilities ETFs and Figure 2 shows the five best and worst-rated Utilities mutual funds. Not all Utilities sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 20 to 255). This variation creates drastically different investment implications and, therefore, ratings. Investors should not buy any Utilities ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this sector, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off. Figure 1: ETFs with the Best & Worst Ratings – Top 5 Click to enlarge * Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5 Click to enlarge * Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings The Fidelity MSCI Utilities Index ETF (NYSEARCA: FUTY ) is the top-rated Utilities ETF and the American Century Quantitative Equity Utilities Fund (MUTF: BULIX ) is the top-rated Utilities mutual fund. Both earn a Neutral rating. The Guggenheim S&P 500 Equal Weight Utilities ETF (NYSEARCA: RYU ) is the worst-rated Utilities ETF and the ICON Utilities Fund (MUTF: ICTVX ) is the worst-rated Utilities mutual fund. RYU earns a Dangerous rating and ICTVX earns a Very Dangerous rating. 79 stocks of the 3000+ we cover are classified as Utilities stocks, but due to style drift, Utilities ETFs and mutual funds hold 255 stocks. PPL Corporation (NYSE: PPL ) is one of our favorite stocks held by Utilities ETFs and mutual funds. It is the only Utility stock that earns an Attractive rating. Since 1998, PPL has grown after-tax profits ( NOPAT ) by 10% compounded annually. Over this timeframe, PPL has improved its return on invested capital ( ROIC ) from 6% to 7%, which is the highest ROIC of all 79 Utilities stocks under coverage. Despite the continued strength of PPL’s business, the stock is only up 6% over the past decade and shares are currently undervalued. At its current price of $36/share, PPL has a price to economic book value ( PEBV ) ratio of 0.6. This ratio means that the market expects PPL’s NOPAT to permanently decline by 40% from its current levels. If PPL can grow NOPAT by just 3% compounded annually for the next decade , the stock is worth $59/share today – a 64% upside. Connecticut Water Service (NASDAQ: CTWS ) is one of our least favorite stocks held by Utilities ETFs and mutual funds and earns a Very Dangerous rating. Throughout the history of our model, which dates back to 1998, Connecticut Water Service has never generated positive economic earnings . The company’s ROIC has declined from 5% to 3% over the same timeframe. However, at its current price of $41/share the stock remains significantly overvalued. To justify its current price, Connecticut Water Service must grow NOPAT by 7% compounded annually for the next nine years . While this may not seem like much in terms of profit growth, keep in mind that CTWS has failed to generate economic profits in any year for nearly two decades. Figures 3 and 4 show the rating landscape of all Utilities ETFs and mutual funds. Figure 3: Separating the Best ETFs From the Worst ETFs Click to enlarge Sources: New Constructs, LLC and company filings Figure 4: Separating the Best Mutual Funds From the Worst Mutual Funds Click to enlarge Sources: New Constructs, LLC and company filings D isclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

A New Leading Indicator Of Stock Market Direction

Click to enlarge I just discovered a new leading indicator of U.S. stock market direction, and I’d like your thoughts on its efficacy. The following graph shows the history of the indicator going back to 1998. It forecast the market declines in 2000 and 2008, and is currently forecasting another market correction. A high indicator precedes a market sell-off. A low indicator signals a recovery, and a flat indicator is a predictor of average returns. The returns shown in the graph are the average quarterly returns over the year following the indicator date. They’re rolling 4-quarter averages. Click to enlarge The Indicator I created and maintain the Surz Style Pure indexes that break the stock market into large, middle and small, and within each of these sizes into value, core and growth. Morningstar style boxes use a similar approach, and were introduced several years after I launched my indexes. My index definition for large companies is the top 65% of the market. I sort the 6000 companies in the U.S. stock market by capitalization and start adding until I get to 65% of the total capitalization. I’ve recently noted that the breakpoint for large companies has recently reached its highest point ever – $22 billion. A large company, by my definition, is currently above $22 billion. There are currently 227 U.S. companies that meet this rule, with total capitalization of $16 trillion, which is 65% of the $25 trillion total market size. This large company breakpoint is the indicator shown in the graph above. It has successfully predicted the last two market cycles, and is signaling that a major market decline started last year with more to come. This supports my prediction for a 19% loss in 2016 based on pure fundamentals. So why does this breakpoint indicator work, and most importantly will it work this time? Here are some possible explanations: Mega cap market domination is cyclical, and the (capitalization-weighted) market goes where the mega caps go. It’s just another measure of overpricing, big companies becoming too expensive. Investors flee to the safety of big companies when they’re worried, and worry ultimately turns into panic. It’s not a leading indicator at all. The apparent correlations are spurious. What do you think? Have I stumbled onto something? What is it telling us about 2016? Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.