Three quick tests to make sure the US stock market isn't a turkey

A relentless series of new all-time highs in benchmark stock indices such as the Dow Jones Industrials, S&P 500 and NASDAQ Composite mean that America’s financial markets continue to write nearly as many headlines as its President.

Buoyed by hopes for growth-stimulating tax reform and ongoing faith in the US Federal Reserve’s ability to provide plenty of cheap money while juggling employment and inflation, the Dow Jones Industrials is bearing down on the 24,000 mark for the first time, the S&P 500 on 2,650 and the NASDAQ on 7,000.

For all of that however, American stocks overall have underperformed the MSCI World index in 2017, in total return, sterling terms.

US stocks have lagged their global peers in 2017

Source: Thomson Reuters Datastream based on total returns in sterling terms from 1 January to 28 November 2017

Despite the still-welcome 11.6% total returns in pounds, the US has lagged Asia, Japan, Western Europe and Latin America, owing to its modest dividend yield, a slide in the dollar and ongoing concerns about valuation.

Market-cap-to-GDP and Professor Robert Shiller’s Cyclically Adjusted Price/Earnings (CAPE) ratios both suggest the US stock market has only ever been similarly or more expensive two or three times in its history (1929, 1999, 2007).

All of those episodes ended with a bang rather than a whimper so investors need to be on their guard, despite (or maybe because of) the prevailing optimism. Looking at the US market from a top-down perspective, there are three quick tests they can use – all available for free on the internet – to see whether American stocks are still hot to trot or primed to become a portfolio turkey.

Between them, the Dow Jones Transportation index, Philadelphia Semiconductor Index (or SOX) and the Russell 2000 small-cap stock index can provide a flavour of American economic health as well as risk appetite from a purely financial-market perspective. In sum:

  • The SOX plunged by 4.4% on Wednesday 29 November, its worst day since 17 May, although the index had been surging ahead until that point.
  • The Transportation index had been lagging so bulls will have drawn encouragement from a 3.3% surge on the same day that the SOX sank.
  • The Russell is still steaming higher.

The conclusions are mixed but none of the three is yet to conclusively set the sort of bearish trend that would really set alarm bells ringing.

Testing the tests

There are good reasons for believing that the Dow Jones Transports, the SOX and the Russell 2000 indices are reliable barometers for wider stock market activity.

  • The Dow Jones Transportation index. Richard Russell may have died in 2015 but the legacy of the expert writer on financial markets lives on, in the form of Dow Theory. The idea is that if the Dow Jones Transportation index continues to lead the Dow Jones Industrials higher, then all should be well. This is because if goods are being shipped, then they are being sold and more will be made. But if the Transports index, which includes airline, trucking and rail firms, starts to falter (and the Industrials keep rising) then there could be trouble ahead.
  • The SOX index. The 30-stock index features firms which are involved in the manufacture, sale or distribution of semiconductors. These tiny devices are also a pretty fair proxy for US and global activity, because everything from computers to handheld devices and from cars to industrial robots contains silicon chips. The chip cycle has also tended to be pretty boom-and-bust, owing to both its economic sensitivity and the tendency of chipmakers to add too much capacity when times are good, so their stocks can be a good guide to stock market risk appetite as their share prices tend to follow earnings momentum.
  • The Russell 2000. This is America’s main small-cap index. Small-caps can be a good guide to economic activity (since they tend to be more focused on their domestic market and can add to employee numbers when times are good) and also market risk appetite, since up-and-coming firms tend to come with greater risk to match their growth potential, owing to their more limited resources, product reach, geographic horizon and potentially dependence on one or two key managers.

In addition, the charts for each indicator over the past 20 years suggest that when these indices are doing well the Dow Jones Industrials will do well and when they are doing badly the broader US stock market will do badly – although we must accept that the past is by no means a guarantee for the future.

Strong performance from the Dow Jones Transportation index ...

Source: Thomson Reuters Datastream

.... Philadelphia Semiconductor index ....

Source: Thomson Reuters Datastream

.... and Russell 2000 small-cap index has tended to accompany (or lead) strong returns from the Dow Jones Industrials

Source: Thomson Reuters Datastream

The latest picture

To return to the present day, the good news is that the Russell 2000 is forging new all-time highs of its own:

The Russell 2000 is still going higher

Source: Thomson Reuters Datastream

The mixed news is that the Dow Jones Transportation index has been lagging and not leading of late. That said, the benchmark has also just set a new all-time high, helped by a powerful gain on Wednesday 29 November. Bulls will be pleased if the Transports take the lead once more, as they did after two other periods of torpid performance earlier this year.

The Dow Jones Transportation index is still rolling

Source: Thomson Reuters Datastream

This takes us to the SOX.

The SOX has had its first wobble since May

Source: Thomson Reuters Datastream

The Philadelphia Semiconductor benchmark needs to be watched as closely as the other two. The 4.4% tumble on Wednesday 29 November could:

  • herald a switch from tech and perceived growth stocks back to financials and cyclical, as per the sector rotation discussed by this column two weeks ago, egged on by hopes for tax reform and accelerating growth in the USA.
  • herald a more ominous early sign of a shift in broader risk appetite.
  • be a blip, like the similar drop in May.

The fortunes of this index in particular, favoured as it is by growth-seekers and momentum fans alike, could prove telling as this year ends and the next one begins.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.