Wealth Management

Posted by Jeffrey J. Roach, PhD, Chief Economist

Thursday, December 8, 2022

Should We Be Nervous About Rising Credit Usage?

Consumers are in a pinch: inflation is high and inflation-adjusted wage growth is weak. To support spending habits, consumers are tapping into credit and savings to bridge the gap between high prices and historical spending. Consumer credit figures for October were released yesterday, and the increase was not a surprise. Total credit usage rose by roughly $27 billion, supported mainly by auto sales and credit card usage. Credit card usage pushed revolving credit balances up by $10 billion from September and new student loans and auto purchases drove up non-revolving credit by $17 billion. Are these increases cause for concern? The answer is found in the household debt service ratio (DSR) which is the ratio of debt payments to disposable income.

According to the latest figures, the total household debt service ratio is approaching 10%, still 3 percentage points below the rate preceding the Great Financial Crisis. This level is not yet a cause for alarm, despite the expectations that the ratio will edge higher by the end of this year.

Our base case is the consumer will likely pull back spending in the coming months as economic uncertainty increases, the stock of savings diminish, and real wage growth remains sluggish. As we point out in the 2023 Outlook: Finding Balance, the domestic economy could dip into a mild recession sometime next year but likely avoid the deeper risks facing Europe.

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Conclusion

Wages have not kept up with high inflation and therefore, consumers have turned to credit to fuel purchases. So far, the consumer is in a comfortable spot to manage debt payments but this view is predicated on stable disposable income from a steady job market. As the Federal Reserve continues to tighten financial conditions, the consumer will feel the pressure on household balance sheets and will likely retrench in the New Year, suppressing discretionary spending.

Going forward, we are cautious on the broader consumer discretionary sector. The expected slowdown in 2023 will ultimately lead to a pullback in discretionary spending and sales at retailers. Large publicly traded retailers will not be immune from this pullback, though they may have levers to pull to subdue margin degradation. However, even if current earnings expectations for next year are correct, we see limited upside near term. The LPL Research Strategic & Tactical Asset Allocation Committee (STAAC) continues to hold a cautious view and an underweight to the S&P 500 consumer discretionary sector, from an asset allocation perspective.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks  

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.

Posted by Barry Gilbert, PhD, CFA, Asset Allocation Strategist

Friday, December 2, 2022

The economy added 263,000 jobs in November, a decrease from October’s upwardly revised 284,000 but a large upside surprise from the pre-release consensus estimate of 200,000, highlighting the continued resilience of labor markets even as job growth continues to slow. Adding to the picture of a still robust job market, hourly earnings came in at +0.6% versus a consensus estimate of 0.3%, with on a 0.1% upward revision to October’s number as well.

The immediate reaction from markets was that good news is bad news, as a strong job market keeps an aggressive Federal Reserve (Fed) in play as it continues to fight inflation. Adding to the picture of a still tight labor market, the participation rate declined from 62.3% to 62.1%, helping to keep the unemployment rate at 3.7%.

Following the release of the report, the 10-year Treasury yield climbed, reversing some of yesterday’s sharp decline following Fed Chair Jerome Powell’s speech at the Brookings Institute, and S&P 500 futures fell over 1%. We caution that it can take time for markets to fully digest economic data, but the market direction is in line with what we would expect.

As shown in the LPL Chart of the Day, the three-month average of job gains has been generally slowing throughout 2022. Nevertheless, the current three-month average of 272,000 jobs added per month is still above 95% of the values from 2000–2019.

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Although October job gains were upwardly revised, the September number was downwardly revised by an even larger amount, giving us a two-month net revision of -23,000. While the more recent revision does mean more momentum recently, it does slightly soften the overall picture.

Average hourly earnings climbed to 5.2% year over year. The latest reading on core personal consumption expenditure (PCE) inflation yesterday was 5.0% year over year, although that number was for October. Nevertheless, having wages start to catch up with inflation may help sustain consumer strength. Wage growth may be bad news for markets as it puts upward pressure on inflation and keeps a more aggressive Fed in play, but it’s good news for consumers.

Finally, a low participation rate continues to keep the job market tight. When the pandemic first hit the U.S. economy saw a large number of participants leave the workforce. The number of people entering the labor force has increased in the last four months and continues to bringing the economy back to pre-pandemic trends. The latest participation rates are approaching but still below pre-pandemic rates, suggesting that the labor market could loosen as more re-enter the workforce. We think the high inflationary environment will eventually bring those people back into the workforce who had taken a “gap year” during the pandemic.

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Conclusion

Ultimately, this is not the job report the market wanted to see, with its combination of an upside surprise on job gains, an upside surprise on wage growth, and a weakening participation rate. It is only one report, but the market is clearly recalibrating expectations. The final Federal Reserve meeting of the year takes place on December 14–15. The meeting starts the day after the last Consumer Price Index (CPI) inflation report of the year on December 13, which will give markets a final opportunity to update Fed expectations prior to the meeting.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks 

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.

Posted by Adam Turnquist, CMT, VP Chief Technical Strategist

Thursday, December 1, 2022

The S&P 500 Energy Sector and West Texas Intermediate (WTI) crude oil have meaningfully decoupled over the last several months. The divergence in performance started over the summer and became more pronounced near the end of September when WTI dropped to year-to-date (YTD) lows. Since then, oil has struggled to catch a sustainable bid, while the energy sector has rallied toward multi-year highs. The dichotomy between declining oil prices and the rising energy sector has left many investors questioning how the deviation developed and perhaps most importantly, how might it get resolved. Cutting to the chase, history suggests the performance gap could narrow from a potential rebound in crude oil, while the energy sector may see further gains.

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Uncertainty over China’s economic reopening has been one of the primary catalysts behind crude oil’s underperformance. China’s strict ‘zero-COVID’ policy has dampened demand expectations from the world’s largest oil importer. The recent surge in COVID-19 cases has further complicated the outlook for reopening as new lockdowns are enforced across the country, although there have been some signs of easing restrictions over the last few days.

As the demand outlook from China became clouded, Russian oil output ramped up last month ahead of European Union import bans set to kick in on December 5. According to Bloomberg, Russian oil production jumped to an eight-month high in November. The uptick in near-term supply coupled with a weakening global demand outlook put downward pressure on front-month WTI futures. Longer-term WTI futures contracts managed to dodge some of the recent selling pressure, suggesting the bearish supply and demand backdrop could be a shorter-term issue for oil. For example, WTI futures contracts expiring in May and June of 2023 have held up above their September lows and witnessed shallower drawdowns compared to front-month futures.

At the sector level, improving fundamentals have helped offset weaker oil prices. Over the last several years, energy companies have shifted away from spending on production to returning cash to shareholders. As shown in the chart below, the free cash flow yield (trailing 12-month free cash flow per share divided by price) for the sector is now near 11.0%, more than quadrupling over the last two years alone. At the same time, the sector’s blended forward 12-month price-to-earnings multiple is only at 9.7x. Attractive valuations underpinned by earnings growth have been another major counterbalance to oil price volatility.

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While these factors help explain how energy stocks and oil prices decoupled over the last few months, they do not explain how the divergence could end. In an effort to answer this important question, we analyzed historical periods to identify when the energy sector has significantly outperformed crude oil. The methodology to our analysis is outlined below.

• Calculate the rolling 90-day rate of change (ROC) for the S&P 500 Energy Sector.
• Calculate the rolling 90-day ROC for WTI crude oil futures.
• Create an index based on the difference between the ROC for the energy sector and crude oil (ROC differential index).
• Apply a +2 standard deviation band to the ROC differential index.
• Identify crossovers (signals) when the ROC differential index crosses above the +2 standard deviation band.
• Calculate forward returns for the energy sector and crude oil after each signal.

The bottom panel of the chart below highlights recent signals generated over the last year, including the most recent crossover signal on October 19.

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When applying the model to data going back to 1990, we found 46 filtered trade signals (applied a minimum 20 trading day separation between each signal). The returns for the energy sector, WTI crude oil, and the S&P 500 are highlighted in the table below.

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In summary, we found crude oil historically outperforms with positive returns after significant divergences from the energy sector. In addition, meaningful energy sector outperformance over crude oil does not imply the sector will necessarily turn lower. As shown above, the energy sector has still produced positive forward returns across each period and outperformed the S&P 500 during this timeframe.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks 

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.

Posted by George Smith, CFA, CAIA, CIPM, Portfolio Strategist

Wednesday, November 30, 2022

As November draws to a close, many investors are looking forward to stocks delivering some holiday cheer and a potential December stock market rally. Today we take a look at what clues seasonality data may give us for stock market performance in December. Turns out that while, historically, December has been a very strong month for stocks, in recent years seasonality trends have been weaker, and a December rally has often failed to appear following a difficult year for stocks.

Looking back, historically, to 1950 (chart below), December has been the strongest month as measured by the proportion of positive monthly returns. It beats the next best month, April, with almost 4% more positive occurrences.

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Looking at average returns by month, dating back to 1950, December is the second strongest month, with an average return of just over 1.5%. Over the same time period, only November has a higher average gain—of almost 1.7%. However, when the data is broken out by time period, as shown in the below chart, the average December return has been waning, with average gains of only 0.9% and 0.5% when looking only at the past 20 and 10 year periods. This puts December firmly in the middle of monthly performance rankings over those time periods, with July being the strongest month over the past 10 years. Midterm year Decembers have typically been a little weaker than an average December, but still with a strong 1.2% average gain over the period dating back to 1950.

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The more recent midterm year data shows a similar pattern, with weaker recent December performance than the longer-term history. Recent midterm year Decembers have actually been negative on average, with midterm year Decembers since 2002 seeing declines of -1.3%, and -1% on average since 2012. A December rally has also often failed to appear when the rest of the year has been bad for stocks—as we’ve seen year-to-date with 2022. If stocks have been down more than 5% over the first 11 months of the year, then December has, on average, been around flat, with the average December seeing progressively worse average performance when the rest of year has seen a bigger drawdown for stocks. A decline of more than 15% from January to November, as we have seen this year, has, on average, seen December follow suit and end the month down by 1.4%.

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In summary, longer term seasonals are supportive for stocks in December, and as we explored in this blog, so is the presidential cycle, but shorter term seasonals warrant caution that a December rally may not be in the cards this year.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

For a list of descriptions of the indexes and economic terms referenced in this publication, please visit our website at lplresearch.com/definitions.

All index and market data from FactSet and MarketWatch.

This Research material was prepared by LPL Financial, LLC.

Securities and advisory services offered through LPL Financial (LPL), a registered investment advisor and broker-dealer (member FINRA/SIPC).

Insurance products are offered through LPL or its licensed affiliates.  To the extent you are receiving investment advice from a separately registered independent investment advisor that is not an LPL affiliate, please note LPL makes no representation with respect to such entity.

• Not Insured by FDIC/NCUA or Any Other Government Agency
• Not Bank/Credit Union Guaranteed
• Not Bank/Credit Union Deposits or Obligations
• May Lose Value

Posted by Lawrence Gillum, CFA, Fixed Income Strategist

Tuesday, November 29, 2022

With the Federal Reserve (Fed) embarking on the most aggressive rate hiking campaign since the 1980s, the risks of an economic slowdown have increased. With inflationary pressures continuing to run hotter than the Fed would like, many Fed officials have stated they are willing to continue to keep increasing interest rates—even to the point of sacrificing economic growth—in order to get aggregate demand and aggregate supply back in balance. Although the timing of when interest rates will peak—and its effect on certain asset classes—is uncertain, the Fed’s tight monetary policy is already having an impact on the most sensitive areas of the economy, such as housing and consumer spending. And with less consumer spending, the outlook for corporate borrowers may be challenged in the near term. Muni bonds, however, have proven to be resilient in challenging economic times.

Shown below, is the default rate of muni securities versus their corporate counterparts. As shown, the annual default rate for muni securities (blue line), in aggregate, is significantly below what has historically occurred in the corporate credit markets (grey line). Additionally, muni defaults during economic contractions (grey shaded region) have been relatively benign. According to Moody’s Investors Service, a rating agency, the average five-year municipal default rate between 1970 and 2020 was just 0.08%, which compares to an average five-year corporate default rate of 6.9% over the same period.

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Muni bonds are having their best month in decades as signs of inflationary pressures are easing. Muni debt has gained 4.3% in November (through 11/28), on track for the biggest monthly advance since August 1986. The rally has pared the muni market’s loss this year to 9.1%, which would be the largest annual drop since 1981. With the influx of pandemic-related stimulus money, healthy tax collections, and prudent savings practices, we think the fundamental back drop for many borrowers remains strong. And with the risk of recession increasing, muni securities could be a good area to weather an economic storm.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks 

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.

For a complete list of descriptions of the indexes and economic terms referenced in this publication, please visit our website at lplresearch.com/definitions

Posted by George Smith, CFA, CAIA, CIPM, Portfolio Strategist

Wednesday, November 23, 2022

Now that the dust has largely settled on the 2022 midterm elections, with the Democrats retaining control of the Senate and the Republicans taking a narrow majority in the House, we take a look at some of the historic market trends relating to the election cycle.

We continue to view the midterm result of a mixed government as market-friendly overall. Markets don’t react well to uncertainty so political gridlock is normally a favorable outcome as new measures from the administration are thwarted by the opposing party. We explored some of the market data and how it relates to mixed government in our earlier blog, found here.

In addition to the political makeup of the government being supportive for stocks, as shown in the chart below, we are also approaching a stage in the presidential cycle that has also been historically supportive. Year three of the presidential cycle has returned almost 17% and been positive 89% of years since 1950, more than any other year of the cycle.

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Analyzing quarterly performance data tells a similar story with 4Q of year two of the presidential cycle the second strongest quarter, behind only the subsequent quarter, Q1 of year three. Q4 2022 has already seen a return of over 11% following the trend of historic strength during this period. Q1 of year three of the presidential cycle has seen a positive return in over 94% of all occurrences since 1950, the highest of any quarter. It also has the highest average return of all quarters. The average returns do noticeably drop later in year three, with Q3 average returns barely positive.

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Looking at the monthly market data for midterm years, November has been the second strongest month, and November 2022 has followed this trend. While a lot weaker than the returns seen historically in October and November, when political uncertainty is often resolved, December of a midterm year has still been fairly strong. December is the third strongest midterm year month but caution should be taken as only two-thirds of historic occurrences have been positive.

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IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

For a list of descriptions of the indexes and economic terms referenced in this publication, please visit our website at lplresearch.com/definitions.

All index and market data from FactSet and MarketWatch.

This Research material was prepared by LPL Financial, LLC.

Securities and advisory services offered through LPL Financial (LPL), a registered investment advisor and broker-dealer (member FINRA/SIPC).

Insurance products are offered through LPL or its licensed affiliates.  To the extent you are receiving investment advice from a separately registered independent investment advisor that is not an LPL affiliate, please note LPL makes no representation with respect to such entity.

• Not Insured by FDIC/NCUA or Any Other Government Agency
• Not Bank/Credit Union Guaranteed
• Not Bank/Credit Union Deposits or Obligations
• May Lose Value

Posted by Lawrence Gillum, CFA, Fixed Income Strategist

Tuesday, November 22, 2022

The shape of the U.S. Treasury yield curve is often looked at as a barometer for U.S. economic growth. More specifically, it reflects how the Federal Reserve (Fed) intends to stimulate or slow economic growth by cutting or raising its policy rate. Each tenor on the curve is roughly the expected policy rate plus or minus a term premium (the term premium represents the expected compensation for lending for longer periods of time). In “normal” times, the yield curve is upward sloping, meaning longer maturity Treasury yields are higher than shorter maturity Treasury yields. However, when, like now, inflationary pressures are apparent and the Fed wants to slow aggregate demand, shorter maturity securities could eventually out-yield longer maturity securities, inverting the yield curve.

The predictive record of yield curve inversion depends on which parts of the yield curve are inverted. Two popular yield curve indexes are the differences between the 2-year Treasury yield and the 10-year Treasury yield (2Y/10Y) and the 3-month T-Bill and the 10-year Treasury yield (3M/10Y). Of these two, the 2Y/10Y is the most popular within the financial media (likely because it tends to invert before the 3M/10Y), but the predictive signal of the 3M/10Y has been more robust.

The past six times the 2Y/10Y part of the yield curve inverted, a recession followed, on average, 18 months later. However, the length of time between the quickest time to recession (6 months) and the longest time until recession (nearly 36 months!) complicates the signal and in the Fed’s words, the relationship is probably spurious. As such, we (and the Fed) tend to put more credence on the 3M/10Y, which has had a better track record in predicting recessions with a lead time of about four to six quarters, but as few as two quarters ahead.

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The 3M/10Y signal has predicted essentially every U.S. recession since 1950, with only one “false” signal, which preceded the credit crunch and slowdown in production in 1967. There is also evidence that the predictive relationships exist in other countries, notably Germany, Canada, and the United Kingdom. Further, a signal that lasts only one day may be dismissed, but a signal that persists for a month or more should be looked at carefully. The current 3M/10Y inversion began in earnest in October, so using historical data as a guide and according to this quantitative metric, we’re likely at least two quarters away from recession. Finally, it’s also important to note that yield curve inversion does not provide much evidence in terms of length and/or magnitude of a potential recession. Over time, we’ve seen deep inversions with shallow recessions and shallow inversions with deep recessions. The signal only provides information on if a recession is likely over the next few quarters. We think any economic contraction will likely be a shallow one due to the continued strength of the consumer.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

All index and market data from FactSet and MarketWatch.

This Research material was prepared by LPL Financial, LLC.

Securities and advisory services offered through LPL Financial (LPL), a registered investment advisor and broker-dealer (member FINRA/SIPC).

Insurance products are offered through LPL or its licensed affiliates.  To the extent you are receiving investment advice from a separately registered independent investment advisor that is not an LPL affiliate, please note LPL makes no representation with respect to such entity.

• Not Insured by FDIC/NCUA or Any Other Government Agency
• Not Bank/Credit Union Guaranteed
• Not Bank/Credit Union Deposits or Obligations
• May Lose Value

Posted by Adam Turnquist, CMT, VP Chief Technical Strategist

Friday, November 18, 2022

LPL Research explores point and figure analysis and how it can be utilized to define market conditions. Despite recent overbought readings, history suggests buying pressure may not be over.

Background

Point and figure (P&F) analysis dates back to the 19^th century. In an era with no computers to record stock prices every day, filtering price based only on a predefined box size (consisting of columns of X’s or O’s) became a popular solution to track price action for investors. In general, rising prices equate to a column of X’s and declining prices are represented by a column of O’s. Based on the composition and position of these columns, objective buy and sell signals can be easily generated.

Jeremy du Plessis, widely considered an expert on the subject, considers P&F charts the ‘mouthpiece of the market’ as the “‘chart moves only when the market moves and only where there is significant movement in the price” (Jeremy du Plessis).’

Example

The P&F chart below shows the S&P 500 based on data over the last year. The box size is 50 points and reversals of a column require a price move of at least three boxes. For example, in order to add a new column of O’s right now, the S&P 500 would need to close below 3,900. Similar to the S&P 500 price chart, you can also depict a clear price downtrend despite some near-term breakouts.

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Applying P&F Analysis to Define Broader Market Conditions

The Bullish Percent Index (BPI) evolved P&F analysis into a market breadth tool. This indicator ranges from 0% to 100% and represents the percentage of stocks within an index that have a current P&F buy signal. Readings above and below 50% are considered bullish and bearish, respectively. The BPI can also be utilized to identify overbought (readings above 70%) and oversold conditions (readings below 30%).

The chart below highlights the S&P 500 and its BPI. The current reading shows 70.2%, which is generally considered overbought. However, in a strong uptrend or bull market, overbought conditions should develop as momentum builds.

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Historical data supports our thesis that overbought does not always mean the buying pressure is over. The bar chart below highlights forward S&P 500 returns after the BPI crossed above 70 filtered for trade signals at least 10 trading days apart (since 1996). For comparison, we also analyzed when BPI crossed below a bottom 95^th percentile reading, which equates to 32 (same 10 trading day filter applied).

BPI Signal Performance

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In summary, the recent overbought BPI reading does not mean the recovery off the October lows is over. Forward 12-month returns following an overbought reading averaged 11.3% with 82% of signals producing positive returns. This data also resonates with an old technical analysis axiom, “The most bullish thing a market can do is get overbought and stay that way.”

In terms of oversold signals, they historically outperform after 1, 3, and 6 months, although overbought signals notably have positive performance during these timeframes.

Works Cited

Jeremy Du Plessis. The Definitive Guide to Point and Figure a Comprehensive Guide to the Theory and Practical Use of the Point and Figure Charting Method. Petersfield Harriman House Publishing, 2006.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks 

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.