Some studies have shown that most of a stock’s return is due to the direction of the trend in a bull market. This can be seen in stock market breadth data. Breadth indicators include the advance-decline line and other data series that measure the number of stocks going up or down.
On days when broad market averages like the S&P 500 close higher, we generally see most stocks close up and breadth is positive. When the S&P 500 is down for the day, we usually see a majority of individual stocks fall and breadth is negative. This is true for weekly and monthly data as well as daily time frames.
Bull and bear markets also tend to play out on a global scale, and the indices of most countries will move up and down together. This tendency of global stocks to move together has been increasing in recent years as global economies have become increasingly interconnected.
Stocks and ETFs with high volatility tend to be among the biggest winners in bull markets and biggest losers in bear markets. For traders, this means that if they expect to see a bull market in the United States, they should consider investing in a foreign stock market that has a good degree of correlation to U.S. markets that also has a history of volatility. Italy fits that description.
The chart below shows a broad index of Italian stocks (the blue dotted line) and the S&P 500 (the green line). To make the indexes comparable, each was set to equal 100 in 1980. While the absolute levels of the index are changed in that way, the direction and size of the trends becomes easier to see. Over the long term, the direction of the trends in U.S. and Italian stocks has been similar, but the magnitude of the moves in the Italian market has been significantly greater.
Over the past 10 years, Italian stocks have been about 27% more volatile than U.S. stocks. Over the past three years, volatility has increased slightly.
In addition to being volatile, Italian stocks also appear undervalued. At the beginning of the year, Italian stocks had a cyclically-adjusted price-to-earnings (P/E) ratio (CAPE) of 8.4, well under the historic average of 21.8 for that market.
The CAPE uses an average of earnings over a business cycle. It is less prone to large swings because it uses several years’ worth of earnings data. This indicator was popularized by Yale professor Robert Shiller, who demonstrated that CAPE can be used to develop long-term market forecasts.
Single-digit CAPEs can be used as buy signals in global stock markets. According to research done by Mebane Faber, the average one-year gain in international markets after CAPE falls below 10 is 25.9%. Over the next three years, low-CAPE markets provide an average annual gain of 17%.
Italy is also a short-term buy. Under my 26-week rate of change (ROC) system, iShares MSCI Italy Index (ETF) (NYSEARCA:EWI) is a buy this week. This system buys when risk is low and the ETF has high relative strength (RS). The RS rank of EWI is 100, meaning that it has been among the top performers over the past six months.
This system also uses a risk indicator and avoids markets when the asset class is weak. International stocks have given a buy signal this week, and EWI is currently the strongest international ETF that I follow.
After adding EWI, the 26-week ROC portfolio will hold four positions:
This article was originally written by Michael J. Carr and posted on ProfitableTrading.
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