The maxim “Prescription without Diagnosis is Malpractice” can be applied to many areas, particularly in investing in the stock market where playing hunches, commercing in tips, and following the social media crowd can be a poor basis for an investment decision. Getting at that diagnosis of the market though requires doing the hard and complex work of intensive research and thoughtful analysis. The question then comes in as to what tools, procedures, tests do you apply to reading the market to come to an appropriate prognosis and an informed course of action?
It is no small undertaking trying to get a sense of what major influences affect the market and what stock price action is saying right now. Tactical strategies, in particular, have been developed to remove emotions from our investment decision making in order to determine the subjective reality of what is happening in the underlying stock market. There has been a great deal of research that has been done in developing models, choosing indicators to follow, and studying movements and interactions between the multivariate market forces at work to help investors make decisions at the margin and help navigate the market.
To better understand how to diagnose and be prescriptive in investing in the market, we reached out to Doug Ramsey, Chief Investment Officer, as well as Scott Opsal and Chun Wang, Portfolio Managers and members of the Asset Allocation Committee of the Leuthold Group – a Minneapolis-based market research and an early pioneering tactical money management firm that offers a family of mutual funds, SMAs, and the Leuthold Core ETF (NYSE: LCR). We asked them questions to learn about their Major Trend Index (MTI) which provides a disciplined tool as a guide on the health of the market which they share with institutional investors and financial advisors.
Hortz: Can you give us a brief overview of your Major Trend Index (MTI) and its role in your investment process? What was it designed to accomplish?
Ramsey: The Major Trend Index provides a weekly monitor of the overall health of the U.S. stock market from both a fundamental and technical perspective. It is currently comprised of 131 indicators and sub-models grouped into four broad categories: Valuation, Cyclical, Sentiment, and Technical. Its status (Positive, Neutral, or Negative) aids us in adjusting levels of equity exposure in our tactical portfolios.
Hortz: Why did you pick these four market areas of Valuation, Cyclical, Sentiment, and Technical to arrive at a diagnosis on the overall health of the market? What does each area tell you?
Wang: We recognize that today’s market is not only constantly changing but also changing at a faster pace. A major market theme can emerge out of any asset class or segment of the market. The four categories of the MTI model are designed to be broad enough so that we can adapt and evolve with the market.
While the Technical category primarily focuses on the internal health of the equity market indicated by price/volume related metrics, all other categories can capture broader cross-asset themes. The Valuation category not only looks at equity valuation relative to its history but also relative to bonds. The Cyclical category is even broader, encapsulating drivers that are most relevant to a number of major asset classes, such as treasuries, credit, commodities, and FX. Information embedded in futures/options market is heavily utilized in the Sentiment category to gauge the potential direction of capital flows. Together, these four categories give a more complete view of the stock market in a multi-asset context.
Ramsey: Those four factor categories are broad enough to capture everything we believe is relevant to our tactical time horizon, which we would describe as intermediate-term in nature.
Hortz: How did you determine the underlying 131 indicators and sub-models that comprise these four broad market areas?
Ramsey: The total number of individual inputs has ranged between 130 and 180 over the years. In some cases, though, a single input may in fact be a consensus model of three or four indicators. For example, our Quattro Model monitors trends in cyclical stocks, defensive stocks, market breadth, and bonds, yet it is counted as just one of the 131 inputs.
Testing of the individual inputs has been exhaustive and poses some difficulty because the statistical “figure of merit” varies according to the nature of the input. For example, with our Valuation metrics, we are looking for measures which historically have been highly correlated with the seven-to-ten year annualized forward total returns of the stock market. In contrast, the relevant forecast horizon for most of our Sentiment measures is one to six months. In the Cyclical category, which tracks monetary and economic trends, some inputs possess significant forecasting power, while the value of other inputs is better captured when they are tested as binary (bull or bear) decision models, rather than as forecasting tools. The test methods required for us to evaluate the inputs across the Technical category are even more diverse.
Hortz: How do you work with all these variables to understand what is happening within the markets?
Ramsey: What you might be getting at with that question is what we internally refer to as “cyclical context.” In other words, there are times in a business cycle or stock market cycle in which some inputs might have very little to say, while later in the cycle they can become critically important. Testing can help identify not only what is important, but when it is important. But there is no substitute for “living” with a set of indicators, so to speak, across multiple market cycles.
Opsal: We use a “weight of the evidence” process, which acknowledges that different indicators may be flashing different signals at any one time. We consider the totality of our indicators to look for a broad, consistent message arising from the cumulative readings of the various indicators.
We also recognize, as Doug just mentioned, that different signals may have more or less relevance at different times. For example, investor worries today center around the risk of recession in the coming months. In that case, we pay close attention to our cyclical indicators as they speak most directly to that concern. Conversely, coming off a bear market low we might listen more closely to valuations, realizing that investments made at particularly favorable valuations have a strong probability of outperforming.
Another consideration that influences our interpretation of the signals is varying lead times for different indicators. For example, monetary and fiscal policies tend to act on the economy with a lag of many months, whereas measures of consumer confidence tend to reflect conditions in the here and now.
Hortz: I am publishing below your MTI as of the week ending October 20, 2023 below as an example. Can you walk us through how to read it? What is it telling us about the current health of the stock market and whether we should change our equity exposure?
MTI as of week ending October 20, 2023, Leuthold Group
Opsal: Each of our categories can score between -5 and +5, represented by red or green diamonds. In this chart, all four groups register negative, and this suggests the market is particularly vulnerable and that a cautionary, defensive position is in order. A series of positive, green diamonds would suggest conditions are favorable for equity exposure. The composite MTI reading leads to a decision on the portfolio’s overall equity exposure relative to a neutral weight. Our neutral weight is 50% equities, within a range of 30% to 70%. Thus, this chart is definitively a cautious MTI reading that calls for an equity weight well below 50%, while a majority of green diamonds would lead us to bring equities up toward 60% or more.
Ramsey: As of the date of this chart, we saw for the first time since late January 2022 (only a few weeks after the January 3, 2022 S&P 500 bull market peak), all four of the MTI’s factor categories are negative. Despite the S&P 500 having gone nowhere for 2 ½ years and a Russell 2000 that was trading below its highs of 2018, our Valuation work does not find much appeal here. Of course, under the right liquidity conditions (think 2020-21), overvalued markets can still go up. But liquidity and monetary trends have been very negative for the last year and a half (as captured by our Cyclical category), and the Technical work shows the market was finally beginning to buckle under those conditions. Sentiment remains a mild negative, indicating too much optimism relative to the depth of the correction since July highs.
Given the weight of this evidence, our tactical portfolios were positioned at the time with net equity exposure of 43%, in the bottom third of the guideline range of 30-70%. Here is a link to the full commentary published on October 24, 2023 and this link to our website research page gives you our current and ongoing MTI charts.
Hortz: What are your next steps in your investment process to arrive at a prescription or course of action in your portfolios?
Opsal: Our investment process is built around a series of disciplines, each addressing a particular aspect of portfolio construction. The MTI guides our overall asset class decision of setting the appropriate exposure to stocks vs. bonds. Once that call is made, we have other tools that guide us in choosing individual groups and stocks (Select Industries), identifying equity hedges (AdvantHedge), and positioning our fixed income holdings. Each of these disciplines is a multi-factor process designed to consider multiple viewpoints and our decision-making process places the discipline’s findings ahead of emotional responses to market activity.
Hortz: How does Leuthold work with financial advisors and institutional money managers? Any thoughts you can share on how best to use your research and strategies in their investment portfolios?
Wang: Advisors and money managers come to us for advice. Decades of collective market knowledge and multi-asset expertise give us the ability to offer superior risk-adjusted long-term performance as well as thoughtful research. Our clients appreciate our process that is both disciplined and flexible, and our ability of incorporating both top-down and bottom-up strategies. Our go-anywhere multi-asset approach fits well in the tactical/equity alternative portion of their portfolios.
Opsal: The Major Trend Index is calculated weekly and is used to help determine net equity exposure in our flagship Core Investment Fund (LCORX,LCRIX). The fund is a pioneer in the tactical asset allocation category often used by advisors as a defensive equity, equity alternative, or simply as an allocation in the alternative space. The long-term goal of the strategy is to produce equity-like returns with less volatility.
We like to share our weekly Major Trend Index updates and commentary openly with investors in our funds and financial professionals so they know in real time the rationale for our decisions. Of course, given our foundation as a research provider, we have additional insights to share with those who want to dig deeper.
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