Saturday, August 29, 2015

Weekly Market Summary

Summary: Waterfall events like the current one tend to most often reverberate into the weeks ahead. Indices will often jump 10% or more higher and also attempt to retest the lows.  Volatility will likely remain elevated for several months. But the fall in equity prices, which has knocked investor sentiment to its knees, opens up an attractive risk/reward opportunity for investors. Further weakness, which is quite possible, is an opportunity to accumulate with an eye toward year-end. However, a quick, uncorrected rally in the next week or two would likely fail.

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Equities ended the week higher: SPY and DJIA rose 1% and NDX rose over 3%. Outside the US, Europe gained 1% and EEM gained 3%. The biggest mover was oil, which gained 12%.

The last two weeks have been remarkable. On August 17, SPY closed less than 1% from its all-time closing high. A week later it had lost 11%. And then three days later it had regained half of those loses, jumping 6%.

A drop that much, that quickly, is very rare. According to David Bianco, it has happened only 9 times in the more than 20,000 trading days in the past 80 years. All of these occurrences were precipitated by (perceived or real) political or economic crises.

Saturday, August 22, 2015

Weekly Market Summary

Summary: Strong downward momentum usually has follow through. US indices are mostly within a few percent of significant support levels. The selling this week registered noteworthy extremes in breadth, volatility and sentiment. Friday probably will not mark the low, but risk/reward over the next month looks favorable.

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For the week, SPY and DJIA dropped 5.6%, NDX 7.4% and RUT 4.6%. For SPY, it was the biggest weekly decline since August/September 2011 and May 2010.

These numbers tell you that the decline this week was primarily about large cap stocks. Not only did small cap stocks outperform but small companies within SPY outperformed larger ones.

Investors will come up with any number of reasons for the sell off. To us, the most important aspect is this: 80% of the selling over the past two weeks has taken place overnight. In fact, before Friday, cash hours showed a gain over the prior 8 trading days. SPY has lost $9.30 overnight since August 10. That date corresponds to the decision by the PBoC to allow the Yuan to depreciate, which set off a cascading effect in other currencies.

There have been few earnings catalysts during this selloff, as most companies have finished reporting 2Q results. Macro data has also been light and positive: housing starts rose to a new 8 year high and retail sales recovered to post a 2.3% annual gain in real terms in July.

The FOMC, meanwhile, remains divided on whether to raise rates in September. The probability of such a hike fell this week, but it is still higher than it has been for any other month in the past.

That the main catalyst for the selloff was events outside the US suggests that the selling is more likely to be relatively short-lived and contained.

Let's look at an example. At its worst, the 1997 Asian financial crisis, which involved currencies throughout the region losing 50% of their value and large loan packages from the World Bank and IMF, resulted in SPX losing only about 5% over two weeks in August. SPX remained in choppy turmoil the remainder of August, then rose 8% in September. The crisis spread over the coming months, but the downside never expanded and the overall trend in SPX was higher.

Wednesday, August 19, 2015

Fund Managers' Current Asset Allocation - August

Summary: Overall, fund managers' asset allocations in August provide conflicting views on sentiment.

On the one hand, fund managers' cash remains at the highest levels since the 2011 and 2012 equity lows and the panic in 2008-09. This is normally contrarian bullish.

However, allocations to equities rose over the past two months and are above the mean. Cash levels are high because fund managers are underweight emerging markets, US equities, commodities and bonds. In August, their exposure to European and Japanese equities increased.

Moreover, fund managers remain very overweight "risk on" sectors: allocations to discretionary, banks and technology are well over their means. Allocations to defensive sectors, like staples, are near all-time lows.

Net, this is not the sentiment profile of investors who are fearful.

Regionally, allocations to the US and emerging markets are at very low levels from which they normally outperform on a relative basis. The dollar is also considered highly overvalued, and BAML fund managers have been prescient in the past in calling turning points in the dollar.

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Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal.

To this end, fund managers became very bullish in July, September, November and December 2014, and stocks have subsequently sold off each time. Contrariwise, there were some relative bearish extremes reached in August and October 2014 to set up new rallies. We did a recap of this pattern in December (post).

Let's review the highlights from the past month.

Fund managers cash levels remained over 5% for a second month, the first time it's been this high for two months in a row since early 2009. This is an extreme and it's normally very bullish for equities (green shading). Note that cash levels haven't been much below 4.5% since early 2013.  

Tuesday, August 18, 2015

How Asset Classes Have Responded To The First Rate Hike

Summary: How have different asset classes in the past responded when the FOMC has raised rates for the first time? Commodities were the best performing asset; they boomed.  The dollar sold off. Equities usually rallied into the decision, then sold off, and then rallied again. Treasury yields rose. The total return for high yield bonds was usually positive.

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On September 17, the FOMC will meet. And expectations are that the Fed will enact a 25bp rise in rates. This would be the first change in rates since December 2008, and the first rise in rates since June 2006 (here).

The question for investors is: how might various assets classes react? To answer, we can look at how they have reacted in the past.

Before looking at the data, consider this: a rate increase means that the economy is improving enough that employment and inflation are considered to be well on the path to being healthy. You would expect, therefore, that stocks would do well if the Fed felt comfortable raising rates. An improving economy also implies demand for commodities and lower default rates, meaning that commodity prices are rising and high yield bonds are at least stable.

And in fact, this is what usually happens when the Fed raises rates for the first time: stocks and commodities rise and high yield bonds have a positive return over the next year (the average length of time rates rose). The chart below covers the period after the first rate hikes in 1983, 1986, 1988, 1994, 1999 and 2004 (data from Allianz).

Saturday, August 15, 2015

Weekly Market Summary

Summary: Price action in US equities is weak. Two potential opportunities to kick off a rally failed this week. Despite this, short term sentiment and seasonality support a move to the upper end of the range. Ultimately, lower lows are still ahead over the coming weeks.

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US equities had two opportunities to kick off a rally this week. Neither had much follow through.

On Monday, positive breadth was 89%; days like these typically indicate strong buying interest among big investors and thus the initiation of a rally. The most recent ones were in October and December 2014 and January and February 2015, and equities rose higher each time. This one failed the next day, giving back all the gains. The last time this happened, at a low, was in the turbulent summer of 2011.