Escaping a Desert Island
If you were on a desert island and the only way out is to “crack” the stock market, and you are given three technical or financial indicators, what would you pick to escape? On a recent episode of one of my favorite investing podcasts, The Compound and Friends, they hosted Denise Chisholm, the Director of Quantitative Market Strategy at Fidelity. Her answer was median earnings growth, credit spreads, and valuation spreads. I wanted to explore these three ideas in more detail to better understand if they could help with understanding the market in the future.
Median Earnings Growth-
This is a leading indicator that can project the future of the market. The idea is to capture how the overall market is growing. Increased earnings growth means more jobs, more spending, and overall stability. Adjacent indicators such as wages can be a lagging indicator because it is the effect of median earnings growth, which means you will always be reliant on “old” news. Additionally, overall earnings growth can be misleading. As a case in point, the MAG 7 could be over representative in the overall earnings growth, which can lead to false overall confidence in the market. Increases in median earnings growth can be an indication of bull markets in the next year.
Credit Spreads-
Another important indicator is credit spreads. As a basic principle of economics, investors are risk-averse. When they lose confidence in the market, investors sell risky assets and buy safer ones. This creates the spread, and the differential can be an indicator to estimate the market’s direction.
There are two ways to view this indicator. First, you can “flow” with the market. Tight spreads, meaning the differential between risky and safe bonds is small, represent confidence. Tight spreads can be an indicator of bullish markets. The opposite is true of wide spreads—investors are selling risky assets due to a loss of confidence.
This brings us to the second way to read this indicator: as a contrarian. As the spread increases, risky assets must lower prices to make their bonds more attractive. This can position you favorably in the market by allowing you to buy at lower prices. According to Denise Chisholm, she focuses on high-yield spreads in particular.
Valuation Spreads-
This is very similar to credit spreads. Valuation spreads are about the difference between cheap and expensive stocks. The same principles apply: bigger spreads represent fear, while tighter spreads represent confidence. As an investor, you can use this to inform your decisions in the same way, because large spreads will offer cheap stocks at a favorable price.
The only question that remains is how we can use this information to inform our decision making. As always, indicators are analogous to breadcrumbs. They leave clues to inform us, yet we should not take 1 or even three to represent the whole picture.
These indicators help shape how we should invest for medium to long term and not for individual stocks. I think before entering positions these tools can help determine when and how to invest.
A popular investing strategy is rolling six-month to one-year options (calls or puts) on the SPY or other large ETFs. The reason for this is increased profits compared to buying stocks with the added benefit of protection for drawdowns, because it is a play on a large portion of the market. I believe these three indicators can be a major benefit for investors who use this strategy. It can provide better estimates of the future of the market and what and when to enter. In a paper account I will be using this strategy and showing my results in the future.
If you have any questions or insights please contact me at knightdigitalm@gmail.com.
