Follow the money

Some of my research involves sentiment indicators, which measure the level of bullish or bearish behavior by two distinct groups of investors.

One group, sometimes referred to as the “smart money,” includes large institutional traders such as pension managers and corporate insiders. They tend to be fairly accurate when assessing where and when to invest.

The other group, known informally as “dumb money,” consists of less sophisticated investors. Mutual fund buyers, small-dollar retail traders and small speculators tend to be wrong more often than right when assessing their investment options.

There are many ways of quantifiably tracking both of these groups, including:

* The AAII Survey (American Association of Individual Investors), which tracks bullish vs. bearish sentiment by retail investors (dumb money);

* Insider trading activity tracked by the major exchanges, which tracks buying and selling activity by corporate insiders (smart money);

* Commercial hedge positions (smart money); and

* The US Rydex group of mutual funds, who publically report flows in and out of their mutual funds (dumb money).

Research that I currently follow shows a fairly high level of “dumb money” optimism on the stock market right now – a signal for caution.

Looking ahead

There are some other factors that may also negatively influence this summer’s returns more than usual. One is a tendency for weaker stock markets to occur in the second and third quarters of the second year of the 4-year Presidential electoral cycle.

There is also a tendency for markets to experience weaker than normal performance during years which follow a 20 per cent (or higher) S&P500 return, as was the case in 2013. And, like the presidential cycle noted above, this weakness, if it occurs, tends to happen in the second or third quarter.

Moreover, valuations on the markets are not cheap right now. A case could be made for a normal, healthy correction based simply on a reversion to mean valuation measurements on the major U.S. stock markets. For example, the large capped S&P 500 index has a current (trailing) PE ratio of over 19 times vs. its mean (average) trailing PE of 15.5.

Another valuation model that some investors follow is the Shiller PE ratio. The Shiller PE, also known as the Cyclically Adjusted PE Ratio (CAPE Ratio), is based on average inflation-adjusted earnings from the previous 10 years. CAPE is over 25 at this time. This is a level well over its historic average of 16.5.

More importantly, Dr. Shiller’s indicator has historically predicted market corrections when it has reached about 24 or higher. For graphs of the Shiller PE and the traditional PE ratio on the S&P 500 and other markets, as well as other fundamental valuation indicators, I’d recommend readers visit www.multpl.com.

Canadian and US market outlook

Adding these factors to my usual seasonal discipline to “sell in May and go away”, we at ValueTrend expect to reduce our equity exposure leading into the summer.

Interestingly, markets tend to experience greater than normal fourth quarter returns after second- or third-quarter pullbacks. So the trick will be to buy stocks later in the summer or fall with our cash holdings in anticipation of a strong finish to the year.

So much for U.S. stocks and markets. But what about our home and native land? From a seasonal standpoint, the TSX has been entering its traditionally weaker period earlier than the U.S. markets in recent years.

While the S&P 500 continues to be a better bet to “sell in May and go away”, the TSX has been peaking much earlier than that recently. In fact, in 2011, 2012 and 2013 the TSX sell point arrived in late March.

Those summers were flat to bearish for our TSX index. Fundamentally, some work done by Scott Barlow, the Globe & Mail’s market strategist, showed that the TSX is actually more expensive from both a trailing and forward PE ratio perspective.

He notes that the TSX tends to underperform the S&P 500 going forward over a two-year period when the TSX PE ratio is at premium to the US market. The seasonality factors and fundamental valuation suggest some headwinds for the TSX coming up shortly.

Technical resistance on the TSX 300 chart will also challenge the TSX in the mid-14,000 area. I won’t be surprised to see the TSX exhibit softer performance in the second or third quarters of this year, right along with the U.S. markets.

Having given you some basis for caution over the coming summer or fall months, I’d like to point out that I am NOT a long-termed bear. In fact, I view any pending correction as a fantastic opportunity to invest in stocks that may fall to attractive price points.

So keep a bit of cash on the sidelines as we enter the summer months, just in case some of the factors mentioned above prove accurate.

Time for commodities

Meanwhile, one area we do find encouraging right now is the commodity sector. The widely followed CRB commodity index has broken an over three-year downtrend. It’s above its 200 day Moving Average, and has shown strong comparative relative strength vs. both the S&P 500 and the TSX.

This means that commodities, a former lagging sector, are beginning to outperform the markets. This is a sign of my “Rotational Market” thesis hard at work.

Energy has just entered its seasonally strongest period of the year

Leading the charge in the commodity sector have been oil, natural gas and precious metals gold & silver. Of those, the most appealing from a technical perspective is energy (including natural gas) in general and oil in particular.

Energy has just entered its seasonally strongest period of the year, which lasts from February to May.

It’s no wonder that oil has been on a tear recently, based on the traditional seasonal patterns. Horizons Winter NYMEX Crude Oil ETF (TSX-HUC, $11.09) is a good way of trading oil, or you can own individual stocks. We hold a position in Enerplus Corp. (TSX-ERF-$19.17), which has exposure to oil and gas projects in Canada.

While a larger cycle on commodities may put future pressure on the broader CRB trade, it’s obvious that the current picture has become at least near-termed bullish for the broad commodity markets.

One way of investing in the broader commodities index, with a little help in picking the right ones to be invested in, is the Horizons Auspice Broad Commodity ETF (TSX-HBR, $9.59). This ETF, managed by Auspice, is positioned long or flat in the futures of 12 diverse commodities: crude oil, natural gas, heating oil, gasoline, gold, silver, copper, corn, soybeans, wheat, cotton and sugar.

If the Auspice methodology triggers a buy signal on a particular commodity, the Index will take a long position in futures contracts on that commodity. Conversely, a sell signal on a particular commodity will prompt the Index to take a flat (zero weight) position in that commodity, which is essentially moved to cash.

The concept of picking the right stocks at the right time is essential in today’s rotational stock market. I’d encourage you to follow my bi-weekly blog at www.smartbounce.ca for timely technical comments to help you follow where money is rotating.

Keith Richards, Portfolio Manager, can be contacted at krichards@valuetrend.ca. He may hold positions in the securities mentioned. Worldsource Securities Inc. – Member: Canadian Investor Protection Fund, and sponsoring investment dealer of Keith Richards. The opinions expressed are those solely of Keith Richards and may not necessarily reflect that of Worldsource Securities, its employees or affiliates. The contents are for information purposes only and do not represent investment advice. ETFs may have exposure to aggressive investment techniques that include leveraging, which magnify gains and losses and can result in greater volatility in value, and be subject to aggressive investment risk and price volatility risk. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated. Please read the prospectus before investing.