Our Simple Rule Flashes RED

Once again, the S&P500 had a volatile week of trading activity…also holiday shortened…and once again, the S&P managed to bounce a bit. This time it rose just about 1.9%. Volume was light, but that was largely due to the short week. And eased back down to the low 20’s, which would be expected in a week when prices closed higher.

In US macro news, the biggest number of the week was the US payrolls report. In it, the number of new jobs created exceeded expectations, and so did the average hourly earnings. On the other hand, the headline unemployment rate missed badly–it rose from 3.7% to 3.9% on expectations of remaining at 3.7%. Outside of payrolls, the Dallas Fed manufacturing survey missed, as did PMI manufacturing, ISM manufacturing and initial jobless claims (much higher than expected). On the positive side, PMI services beat consensus expectations.

In terms of technical analysis, the two weeks of consecutive bounces has done nothing to repair the longer term (weekly and monthly) technical damage. In fact, it would have been more surprising than not if we had not seen at least a couple of weeks of bounces. Because these bounces have not taken the S&P back up to the 50 day or 200 day moving average, we should expect the bounce to continue until one or both of these moving averages are touched. At that point, the real test will begin—if a bear market mentality has kicked in, then traders and investors will use these technical levels to sell. In other words, these would be the natural levels at which technical traders would sell the rallies…..the opposite of what they did for many years in a bull market cycle (when the bought the dips back down to the 50 and 200 day moving averages).

But the big news for us is that for the first time in many years, our Simple Rule has flipped from being bullish to being bearish. The key US economic indicators that we follow are no longer unanimously positive, and that means that the likelihood of a US recession has risen dramatically. When this happens (and specifically, this happened last week), we turn to our long-term technical system for the S&P500 and it is also flashing a red, or exit, signal. This means that we should use any bounces….such as the ones we’ve been experiencing lately….to sell out of any index funds mirroring the S&P500. And the proceeds of these funds should be redeployed into short-term US Treasury bills and notes, until our system tells us to get back into the S&P500 index.

As a reminder, our Simple Rule keeps us invested in the S&P500 index for about 85% of the time in any given ten year period. So it’s not a common occurrence for the system to tell us to exit. That said, if these signals hold, it’s not unusual to have to stay out of the S&P500 index for at least 12 months.

There is no guarantee that this system works perfectly to forecast an imminent recession and a related bear market cycle, but the number of false positives over the last 50 years of data is extremely low. In other words, it usually works.

Some key problems in adhering to this type of system include: 1) it means that investors may need to sit on their hands for 12+ months and hold mostly US Treasury paper. This is far from exciting and most investors cannot accept such long periods of “doing nothing”, and 2) it means that investors may still incur some drawdowns before the system tells them to exit. No successful system (no matter how success is defined) can eliminate all temporary drawdowns. Some investors cannot stomach temporary drawdowns, and if so, they should stay away from equity investing entirely.

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