Weekly Market Summary

"The S&P has been up 56 of the 88 trading sessions so far. That rate of success is not only extremely rare, it is, borderline, unprecedented. Fifty years of experience suggests streaks ultimately end. For now, stay very nimble." - Art Cashin

The markets are at a surreal moment, one where even the optimists are confounded by how bullish things have become. - Jim Cramer

In less than a month, SPX has run up more than 8%, nearly equal to an average full year of gains. In the process, over the past two months, SPX has dodged a stunning number of obstacles: a break down in ex-US markets, lagging domestic growth stocks, weakness in breadth, deteriorating macro worldwide, strong outperformance by treasuries, sentiment in which fund managers had a near record exposure to equities, and revenue and earnings downward revisions.

SPX has now gained an uncorrected 24% since its November low. This is the longest comparable streak in more than 30 years. SPX is up 17% for 2013, over 50% more than its average annual gain. Nasdaq is on pace for a 7th consecutive month higher, an occurrence with just a 3 in 100 probability. The only times when SPX has been this strong for so long is after a major low, but 2012 was also a strong year (13% gain). 

In short, as Cashin and Cramer note, there is no precedent for the current market. 

What's next?

If your timeframe is long, the current strength should be followed by further gains in 2013 and probably 2014. New highs like those being achieved now are rarely the end of the trend. That should be your long term bias.

Shorter term, we think a 'regular' cycle will intervene in mid-year but fully acknowledge that this is not a regular market. The only time in more than 30 years that an annual correction did not take place was 1995, so it has happened before, but it is a long-shot.

Below is a run down of the major factors we follow. Trend and breadth, the two most important, are both positive, as is volatility. Sentiment, macro and valuation are the biggest negatives.

Trend: Positive. All the US indices and sectors are trending higher, as are most ex-US markets. Cyclicals are catching up with defensives and all sectors have made higher highs in May. There is no divergence but there are two watch outs. 

• First, when the bullish percent has been this high (88%) in the past, SPX has always corrected at least 5% in the next month (chart). 
• Second, the torrid pace in SPX has created a record spread between the 13/34-emas; each time in the past, SPX has moved lower over the next several weeks, then made a higher high before making a much lower low (chart). 
• If you say that the market will look past these watch outs like other warning signs, you're in good company; it's an unprecedented market where anything can happen. 

Breadth: Positive. NYSE has made over 700 net new highs on 5 days in May. That's remarkable breadth. NYSI is strong. Over 93% of the SPX is above its 50-dma. Overall breadth can't be faulted as there do not appear to be any divergences forming. That said, it is strange that there have been four major distribution days but not a single major accumulation day in 2013. 

Sentiment: Negative. Bullish sentiment (AAII, II, BAML) appeared to reach a peak in 1Q and has been in decline since then. This is the typical pattern after a strong run. Other sentiment measures indicate strong bullishness:

• Street expectations for 10% EPS growth after quarterly EPS has been virtually flat since 3Q11 suggests high levels of bullishness among analysts. 
• Junk bonds, which had never yielded less than 6%, now yield less than 5%; this also suggests a high level of bullishness. 
• And then there's this from SentimenTrader.

Volatility: Positive. This might be the single most bullish factor in the market right now. Volatility remains very low and we know from the past that it can stay subdued for several years, during which market returns are above average. Strangely, even in the past, >5% corrections were a regular feature of the market when volatility was low. Not this year.

Macro: Neutral. Economic data has been weaker than expected in both the US and in the G10, a reliable warning for SPX in the past that has not mattered at all in 2013. This is probably the second biggest watch out right now, as, in the past, weak macro has led to lower EPS as well as lower valuation multiples. Investors might say they hate the Fed but their actions suggest a high level of faith in it's current policies.

Seasonality: Neutral. Equity markets are now into the weaker 6 months, when upside returns are lower and downside risks are higher. July, August and September (3Q) are the weakest months. In post-election years (like now), mid-May until mid-June is typically weak.

Valuation: Neutral. On every metric, except Equity Risk Premium (ERP), SPX looks at least 'fully valued' if not overvalued. It's noteworthy, therefore, that ERP has become fashionable lately. Normally, ERP is this high (bullish) because equities have fallen and bonds (safety) have risen. That's not the situation here. Bond yields, driving ERP up, are low due to low inflation and growth expectations globally. Ironically, a fall in ERP would be more bullish. All valuation metrics are faulted, ERP equally so during ZIRP.

• For over a year, the dividend yield on SPX has been more than 10-year treasuries, but the recent rise the former and decline in the latter has neutralized this advantage. This might be significant, as bond funds have been buying equities more than at any time in the past 18 years. 
• Price to sales is at the top of the range; this is significant, as sales growth, like global GDP growth, is flat (in fact, it declined in 1Q13). 
• Price to EPS based on 4% annual growth in 2013 and 2014 is well above recent highs at 15.3x. The market is pricing in more than 10% growth. Maybe this is possible, but 1Q13 EPS growth was barely 3%, so it seems not likely. 
• Shiller's PE10 is at the top of the range.

For us, the question has never been will SPX end the year with healthy gains. Instead, it has been whether a regular counter-cycle will intervene. Our posture since mid-March was to manage risk after a strong run, to expect the counter-cycle in the rally that has occurred every year by May since 1996. This seemed appropriate given the multitude of headwinds detailed above and the fact that SPX was at its 2000-07 resistance top. That advise looks wrong in hindsight. But, faced with the same evidence again today, our position would not differ.

BAML Survey - May

Every month, we review the latest BAML survey of global fund managers. Among the various ways of measuring investor sentiment, this is one of the better ones. These managers oversea a combined $661b in funds.

During 4Q12 and 1Q13. fund managers were reducing cash, overweighting equities and underweighting bonds to levels that are close to the bullish extremes seen at prior equity tops. Equity exposure in March, for example, was the second highest since the survey began in 2001. 

Overall, fund managers are still bullish on risk, but less so than in March and April.  In April, cash levels rose to 4.3%, in the middle of the range; they remain there in May. Equity allocations were reduced to 41% overweight; still near the high end of the range. Bonds remained underweight at a net 38%. 

Recall that these are global fund managers, so reducing some risk in the past two months reflects deterioration in European and emerging markets, especially China. The US market has been diverging higher. In response, fund managers have maintained their overweight bet on the US at 20%. They were 3% underweight the US in January, for comparison. Europe was reduced to 8% underweight in April and May; it had been 15% overweight in January. Managers are now more overweight Japan (31%) than at any time since mid-2006.

You can see from the data that it should be looked at from a contrarian perspective. Fund managers were overweight EEM more than any other market at the start of the year, and it has been the worst performer so far. They are now becoming bearish EEM (3% overweight), so keep it on your radar. They are also more underweight commodities (29%) than at any time since 2008. In comparison, they were 20% underweight Japan in December and it has been the best equity market by far in 2013. 

Survey details are below.

The Annual Mid-Year Counter-Cycle Is Strongly Odds-On

This is an impressive rally. Not only has SPX been up six months in a row but it has risen 21% from the November low and 14% YTD. In comparison, the average annual gain in SPX is 9.5%. Moreover, there has not been a single 5% correction in all those six months. Trend, cyclical leadership, breadth and low volatility all argue in favor of further highs.

Is there precedence for SPX to significantly continue its uncorrected move higher?

Putting the current rally in perspective, the 21% uncorrected gain in SPX since November is now equal to the largest such rally in the last 13 years outside of those following the 2009 low and the Flash Crash.

Weekly Market Summary

SPX entered the 2000-07 resistance zone the week of March 11. In the 8 weeks since, it has traded an equal distance (2%) above and below this level. That all changed on Friday, when SPX not only ran through the top of the resistance zone but gapped nearly 1% above it. Is this a game changer?

There are a number of positives that support this move. Most importantly, $COMPQ and $SOX seem to be leading, having broken higher early in the week. More generally, the past week was led by cyclicals; not just technology, but financials and industrials as well as discretionary sectors made new uptrend highs. And ex-US markets, that were sitting on YTD lows just 10 days ago exploded to new YTD highs. As impressive as the US market was this week, ex-US markets have recently been even more so.

The improvements in trend were also supported by breadth. McClellan has been positive for two weeks and more than 80% of SPX components are above their 50-dma. On Friday, a net 775 NYSE companies made a new 52-week highs.

Objectively, the two most important factors we track, trend and breadth, support higher prices. Add in low volatility and a dividend yield well below the yield on 10 year treasuries and you have the foundation for continued gains in 2013.

Moreover, strong advances usually continue higher. We noted in February that a 7-week in a row advance was typically followed by a higher high in the weeks ahead. That was fulfilled when the subsequent advance took SPX to the start of the resistance zone by March 11. Similarly, the now 6-month in a row advance in SPX should be followed by higher prices by the end of the year. That's the longer term set up.

Weekly Market Summary

SPX has now alternated direction (up/down) every week since March 11. March 11 was also the week SPX entered the 2000-07 expected resistance zone. It had gained 16% in the four prior months. In the seven weeks since then, it has gained a net 1.5%. In other words, 90% of the gains from this rally came before the resistance zone was met. The remaining 10% has come in the choppy trading since early March.

This has been without a doubt one of the strongest rallies in more than 30 years. SPX will likely close higher every month from November through April for the first time in 15 years. 2013 is the first time in 17 years that there hasn't been even a 5% retracement by May. The gain over the past 6 months is 4 times greater than the average annual gain in SPX.

Rallies like the current one have happened before, but they are less than a once in a decade occurrence. What makes this current rise unusual is that it did not start at a major bottom (like 2003 or 2009) but at the end of the successful uptrend in 2012. In the past 13 years, this has happened only once before: 2006-07. That rally eventually went up a total of 21%, just a bit more than the 19% this one has achieved. That rally was followed by a swift 7% decline, then a 15% rally into the major 2007 top. Should that pattern be repeated again now, SPX could rise to 1625, then fall to 1510 before rising later this year to 1740.

Two things are clear: on the one hand, more than 30 years of market history do not support a continued, significant, uncorrected rise in the SPX; and on the other hand, this rally has been successful at defying convention. It's therefore hard to say with conviction what might happen next. That is not a set up which favors disproportionate risk-taking.

Placing The Current Rally In Perspective

Let's place the current rally in perspective to determine whether it is unusual or extreme.

Key points:

• SPX is likely to close higher every month from November through April for the first time in 15 years. It's only the third such streak since 1980.
• The current rally has gone up by a larger percentage than two-thirds of the multi-month rallies of the past 13 years.  With only one exception, its the biggest rally that didn't start at a major bottom (like 2009).
• 2013 is the first time in 17 years that there hasn't been even a 5% retrace by May.
• The gain over the past 6 months is 4 times greater than the average annual gain in SPX.

Weekly Market Summary

In early March, SPX entered the 2000-07 resistance zone. Last week, after 6 choppy weeks of trying to move higher, it finally reached the top of this zone. This week, it fell 4%, ending right back where it was in early March. In the process, it broke the uptrend line that had held the SPX in a bullish channel since November. Downside volume was significant; two days this week recorded more than 90% downside volume, evidence of strong institutional distribution.

Prior resistance aside, there are two main reasons SPX fell. 

First, expectations for FY13 EPS are high. After EPS that has stagnated over the past 7 quarters, the market has been expecting 10-15% growth through the remainder of the year. 1Q13 reporting has started and, while it is still very early, the initial results are disappointing. The beat rate on revenues is the lowest since 2008. This bodes poorly for earnings growth for the rest of 2013, as margins are already exceptionally high and margin expansion has also stalled.  This implies weaker guidance going forward. As a result, whether they 'beat' or not, IBM, GS, GE and others have been sold after reporting, a risk we noted last week.

Second, the current uptrend is extended. Jeffrey Saut says the current rally has gone more than 100 sessions without a 5% pullback, the third longest since 2002. Momentum after a long uptrend typically fades as marginal demand is reduced. Last month, global funds were the second most overweight equities they have been since 2001. This month, global funds reported being net 20% overweight the US market; for comparison, they were 3% underweight in January (post). Margin debt is at the highest since 2007. Without a reset that shakes out weaker hands, it becomes increasingly hard to push prices higher. 

The theme in the market has been yield. This week, dividend paying utilities and consumer staples stocks made new all-time highs, as did junk bonds, and 30-year treasuries made new 2013 highs. Contrast this with US growth-oriented cyclicals; the cyclical index and 4 of the 6 SPX sectors focused on cyclicals closed below their 50-dma. Both the Russell and Nasdaq are also below their 50-dma, as are the Euro 350, emerging markets and All World Ex-US index. 

So what's next? 

Ex-US markets, the Russell, Nasdaq, transport and semi-conductor indices (all of which lead) broke their uptrends in February and March. SPX is following. Those other indices have been chopping in a 5-8% wide horizontal pattern. On the upside, after their first touch of their 50-dma, they retested their highs. SPX touched its 50-dma Thursday and could well be on its way back to 1600. 

The Pattern That Is Developing

One of the oldest axioms on Wall Street is that the market redistributes wealth from the many to the few. It will, in other words, fool the most. Keep that in mind as you read further.

We have previously noted how 2013 appears to be, in many ways, a dead ringer for 2011, a year in which SPX started very strong, following on the heels of a great market in 2010, then proceeded to trade sideways in a 10% band for 5 months. Sentiment, fund lows, sector rotation, ex-US markets and junk bonds have all behaved very similar between the two years. Catch up with this analogy here.

We've also noted the recent pattern in the market, shown in the first chart below. After a long uptrend (blue line), the upward momentum begins to wane, the trend line is breached and trading becomes choppy, with break downs and break outs failing (yellow areas). By appearances, SPX is starting to repeat this pattern now. Having said that, re-read the first paragraph above.

What lends some credence to the pattern playing out again is that we are seeing it in other markets and sectors.

Time to Pay Attention to Macro Again

The Citi Economic Surprise Index (CESI) for the US crossed below zero this week. This is the second time this year it has done so. CESI is indicating that macro data is coming in below expectations.

A couple of points:

Global macro cycles tend to most often be highly correlated. You can see that in the first chart below. The red lines indicate periods where CESI in the US (top panel) has corresponded with downside data from the G10 economies. In the current situation, the US data is weakening at a time when G10 data has already been weakening for several weeks.

If you have been following treasury yields moving higher the past month and commodity prices moving lower this year, this should not come as a major surprise.

In late January, CESI for the US turned negative. In March, it turned positive again. Might this happen again now? It's less likely. In the same chart, note the black circles. The false breaks in US CESI have occurred when the G10 was stronger. That's not the case now.

What are the implications for US markets?

BAML Survey - April

Every month, we review the latest BAML survey of global fund managers. Among the various ways of measuring investor sentiment, this is one of the better ones.

Over the past few months. fund managers have been reducing cash, overweighting equities and underweighting bonds to levels that are close to the bullish extremes seen at prior equity tops. Equity exposure in March, for example, was the second highest since the survey began in 2001.

In April, cash levels rose to 4.3%, in the middle of the range. Equity allocations were reduced to 47% overweight; still near the high end of the range. Bonds remained very underweight at a net 50%. Overall, fund managers are still very bullish on risk.

Recall that these are global fund managers, so reducing some risk in the past month reflects deterioration in European and emerging markets, especially China. The US market has been diverging higher. In response, fund managers have raised their overweight bet on the US (and Japan) to 20%. They were 3% underweight the US in January, for comparison. Europe was reduced to 8% underweight in April; it had been 15% overweight in January.

You can see from the data that it should be looked at from a contrarian perspective. Fund managers were overweight EEM more than any other market at the start of the year, and it has been the worst performer so far. They are now becoming bearish EEM, so keep it on your radar. They are also more underweight commodities than at any time since early 2009.

Survey details are below. Read about the March, February and January surveys as well. The charts (from March) are from an excellent post from Short Side of Long (here), a site I recommend bookmarking.

1. Cash: Cash balances rose to 4.3% (vs 3.8% in January and February, and 4.1% in December 2012). This is the highest in 6 months. Typical range is 3.5-5%. BAML has a 4.5% contrarian buy level. More on this indicator here and see first chart below.
2. Equities: A net 47% are overweight global equities, a 10 percentage point decline from last month (57% in March, 51% in February). March was the second highest equity exposure since the survey began in April 2001. In comparison, it was 35% in December 2012. More on this indicator here and see second chart below.
3. Bonds: A net 50% are now underweight bonds, a decrease from 53% in March and 47% in February. March was the lowest weighting since May 2011. Third chart below.
4. Currencies: Appetite for the dollar is at the highest level in survey history, like March.  On the flip side, Yen bearishness is the lowest since February 2002.
5. Regions: EEM had been the most favored region (overweight 43% in February) but this fell to +13% in April, the lowest since October 2011. Only 13% expect a stronger Chinese economy in the next year, a massive fall from 71% in January.
1. Managers are 20% overweight the US (vs 14% overweight in March and 3% underweight in January), the highest since June 2012.
2. They are the most overweight (20%) Japan since 2007 (versus +15% in March, +7% in February and underweight by -20% in December). Every regional fund manager expects the economy to strengthen in the next 12 months.
3. Europe was reduced to 8% underweight from 4% overweight in March (+8% in February and +15% in January). 
6. Sectors: Sector weighting reflect skepticism over emerging markets and concern about EZ. 
1. Materials weighting is the lowest since 2009.
2. Energy weighting is the lowest on record.
3. Overall, commodities are 18% underweight (-11% in March, -1% in February), the lowest since January 2009.
7. Macro: 49% expect global economy to strengthen next 12 month (61% in March and 59% in February). March was the highest optimism since April 2010. The fall is attributable to Europe; 19% expect strength in the next year, down from 40% in March.

Weekly Market Summary

The story so far has been this: from the beginning of June 2012 until March 2013, SPX rose over 20%. For most of this time, it was strongly supported by US cyclicals and macro data beating expectations, confirmed by rising bond yields. Breadth had started to diverge in mid-February, as had ex-US markets. Low volatility and favorable seasonality were tailwinds.

In early March, SPX first entered the prior resistance zone from 2000-07. Trading became choppier, with SPX alternating directions each day for a nearly three week stretch. Bond yields began falling, with bond prices rising in-line with equities. Macro data has flipped back and forth; in early March it was strong, in late March it was weak. Ex-US markets traded lower and US cyclicals underperformed. After rising over 20% thru February, SPX has subsequently risen only 2.5%.

This week, SPX finally reached the top of the resistance zone at 1590-1600. These are all-time highs. It is impressive and, on its own, bullish. RUT had been leading; it reached new highs in January; DJIA was second, in March. COMPQ has been lagging behind.

The strong bounce that started a week ago Friday continued most of this week. There were a number of positives achieved.

• First, COMPQ made new 12 year highs, after looking like it was falling below trend. The same can't be said for RUT, which broke trend and has been sideways for the past month. Watch this one closely. SPX has never broken trend in 2013. 

• Second, SPX has recently been led by yield producing stocks; the one exception has been the consumer discretionary index (a strange collection including McDonald's, Comcast, Nike and Home Depot). But this week, financials and technology made new 2013 highs. Cyclical participation appears to be broadening, a big positive.

• Finally, there were improvements in breadth, with a new high in $NYAD and 700 net new highs on the NYSE on Thursday. Overall, the picture on breadth is very mixed; breath momentum continues to decline, as does the number of stocks trading above their 50-day.  Read further here on SPX and here on Nasdaq. 

The overall theme in the US market is yield. Neither bonds nor equities are confident about US growth. Equities are rising, but its really being driven by the yield sectors (utilities, real estate, staples) and health care.  Dividend stocks beating cyclicals has not been healthy in the past (chart). Treasuries confirm the weak growth; bond prices are also rising and this divergence will be a watch out until it changes (post and chart).  Economic data in the US and the G10 have not been beating expectations either. And, finally, commodities have been diverging lower most of 2013. Overall, it's a very consistent picture.

Tony Caldaro points out that 75% of the world equity indices he follows are in a downtrend; outside of the Nikkei, the rest of the world is chopping sideways or declining (chart). A change here would be enormously positive. We are watching EEM closely.

The bottom-line is this: Investors are betting heavily that the trend in US earnings is getting set to change. This is a big bet. In the past seven quarters, going all the way back to 3Q 2011, EPS growth has been zero. In 1Q13, it is expected to decline; then, amazingly, it is expected to grow 10-15% in the next three quarters (chart).

Make no mistake, Wall Street is very bullish. If they are right, then SPX is trading in-line with historical norms (chart). In fact, SPX could rise to 1650-1700 this year ($112 EPS at 15x).

But, if quarterly EPS, which has never been greater than $25.9 since 3Q11, stays in this range this year too, then SPX is currently valued over 15.3x, the highest since 2007 and excessive for the low level of growth. Fair value (using the 10 year average PE of 14.2x) would be closer to 1475.

Interestingly, at 1590, SPX is basically in the middle of this 1475-1600 range. Handicap the odds of reaching one or the other and you can figure out your expected reward versus risk.

Guidance during this earnings season is now critical to the upward march of SPX.

May To October Is Less Bad Than You Think

One of the axioms of Wall Street is 'sell in May and buy after Halloween'.  Mark Hulbert says that over the past 50 years, the Dow has an average return of 7.5% from November through April ("winter") versus an average loss of 0.1% from May through October ("summer").

So, is the summer period that awful?

Using SPX instead of the Dow and including dividends, since 1970, the data still favors winter over summer: the average return is 9% in winter versus 2% in summer.

But this data is skewed by some outliers; using median values, winter's return is 8% versus 4% in summer. In other words, while the returns are usually two times higher during winter, the returns in summer are typically positive. You might sell in May and buy back higher in November.

Digging in further confirms this conclusion. Overall, 21% of winters since 1970 have been negative; summers are a bit higher at 28%. Really bad seasons with losses of more than 10% don't favor one season over the other: 7% of winters versus 12% of summers. Summer is worse, but the difference isn't much.

There are two factors at play influencing typical seasonal returns and investor perceptions.

The first one is this: about 65% of the worst months since 1970 occurred during the summer. This is true whether you look at the top 20 worst months or all months with a 5% or greater loss. When a bad month happens, it is twice as likely during the summer as the winter. 

But the other factor, equally important, is that great returns overwhelming take place in winter. Almost half (48%) of winters produce a return of 10% or more, just like the one occurring now. In comparison, only 17% of summers have produced a great return. When a good stretch in the market happens, it is almost three times as likely during the winter as the summer.

The summer months start in a few weeks. The probability of a truly bad month is higher and the probability of a really great stretch of months is much lower. But the expected return over the next 6 months is, on its own, positive. As we have seen in the past few years, a dip in summer is often a great entry point.

Weekly Market Summary

A month ago, SPX entered into the area of strong resistance from its 2000 and 2007 peaks (chart). Since then, SPX has had a weekly open/close range of less than 20 points, or about 1%. In the last 12 days, it has alternated direction (up/down) every day. The character of this market was encapsulated on Tuesday; SPX made a 5 year high yet the McClellan oscillator (a measure of breadth) closed well below zero (-23).

Pure trend followers have been right to say that the trend is up for the US indices. Trend is the single most important factor we follow and we have agreed with them and kept our trend assessment green throughout 2013.

This week, however, the US trend has started to weaken. Both the $RUT and $COMPQ broke their November uptrends and closed at 4-5 week lows, essentially reversing all the gains in March. Small caps had been outperforming SPX in 2013 until this week; now it's a net laggard. SPX has not broken its channel, but it normally follows.

The Euro 350, All World Ex-US, $DAX and 4 of the 6 cyclical sectors of the SPX also broke their uptrend this week, as have DJT and $SOX (click the links to see the charts). These sectors and indices should be leading, and they are instead falling (chart). Hong Kong and EEM are at December's levels. When the rest of the world's indices are near or below the open for the year, it is noteworthy.

The rest of the world's indices are following macro developments. The Eurozone as well as the G10 Economic Surprise Indices (CESI) both fell below zero this week. Before the poor NFP report on Friday, the US CESI was headed back towards zero as well. After a tide of very good data, the economic trend in the past several weeks has been weak. Worryingly, this is a seasonal trend that has developed every year since 2010.

It is notable that the bond market was way ahead of equities in expecting a weakening of economic data. 10- and 30-year treasuries exploded higher this week; we have noted before the importance of these divergences (post and current chart).

The relative low risk of treasuries have now outperformed SPX and $RUT for 4 weeks and have equal performance since late January; treasuries have beaten $COMPQ since early January.  That is an exceptionally poor risk-adjusted return, something pure trend following has missed (and, in our mind, a key short coming of that approach).

Breadth remains poor.

There is not much value in following micro changes in sentiment; investors have been very bullish since February and, to take one example, Investors Intelligence recorded the widest spread between bulls (many) and bears (very few) of 2013 this week. Moreover, Wall Street has upped its targets after its initial estimates were surpassed. But the real tell on sentiment was the mainstream media attention given to the 'Great Rotation' out of bonds, a trojan horse we warned against (post).

Seasonality remains strong in April but we are close to the weakest 6 months of the year. Over the past 50 years, the Dow has risen an average of 7.5% during November-April and fallen 0.1% during May-October. Seasonality becomes a headwind in the next few weeks.

To be completely clear, all of this is not to say that US indices are on the verge of a major plunge. The overall economic trend is improving, albeit slowly. The Fed is accommodative and, despite all the criticism, it's policies have been successful. Our expectation has been for a typical correction followed by further upside. Since 1980, the average annual intra-year correction has been about 15% (median 11%). Read further here. Volatility is in a low period that is reminiscent of the mid-1990s and mid-2000s.  Our stalking horse continues to be the 2011 market. Wait for it, a fat pitch on the long side is coming.

Short term, the US indices appear to be in a sideways pattern that has occurred also during the past few years (current chart). With this as a model, a second test of the 1575-90 resistance area would be normal, as would a pierce of the 50-d. Friday was a strong rebound and short term divergences are positive.

Right Now, Your Risk Is At Least Twice Your Return

The Fat Pitch is about finding the circumstances where your expected return (upside) is a high multiple to your expected risk (downside). This blog attempts to combine a variety of measures to portray the expected risk/return at any given time.

In general, the odds on the long side are strongly in your favor.  Since 1980, the average annual gain for SPX is 9.5% (median is 13%). Every January 1st, that is your expected return over the next 12 months. The probability of making any positive return each year is 76%.

Also since 1980, the average intra-year decline for SPX is 14.7% (median is 11%). Every January 1st, an investor should expect to incur this level of drawdown sometime during the course of the year. Drawdowns of at least 8% occur more than 80% of the time. Drawdowns of at least 15% occur nearly 40% of the time. If you think that you will only suffer a small pullback of under 5% this year, the odds are very strongly against you; this has happened just once in 33 years.

So, what does this mean for our current situation?

SPX has risen 10% year to date. This is already a full year of gains in a typical year. The probability of further gains than this for the whole year are just over half. In other words, it's a coin toss.

Strong starts to the year improve the odds of a positive full-year, but the gains after the first quarter are much smaller. Bespoke (post) notes that a strong start like this one leads to an average gain over the next 9 months of just 1.4% (median of 5.8%). If you buy and hold now, that is your expected return thru the end of the year. The big gains for 2013 are likely behind us.

Against this return you should weigh the average annual drawdown. The upshot is this: right now, on average, your expected risk is 10 times your expected return (14.7% drop vs 1.4% gain). Using median values, your expected risk is twice your expected return (11% drop vs 5.8% gain).  These are poor risk profiles, especially in comparison to those at the start of the year.

The risk-return does not improve when you only look at positive years either. Assuming you knew with certainty that this year would end with a gain of at least 10%, what would be your expected drawdown? The answer is 12%, very close to average and the median.

These results are what we would expect. Last week we looked at strong positive gains in 1Q in the Dow and discovered that many occurred when the prior year was either flat or down. In the other years,  like 2013, all of the 1Q gains were entirely given up in 2Q (post).

The probability of a large gain happening during the next few months before a large drawdown is also small. Since 1980, 88% of corrections have happened by the end of May and 85% by the first week in April (post).

2013 is an unusual year in that it is presenting a particularly tight set of circumstances: strong gains and no correction thru the first 3 months. There are never certainties in the market, but the odds are clearly not in your favor until some of the gains from the first quarter have been given back.

The chart below shows the calendar year gains and intra-year drops in SPX since 1980. The red line is the average gain; the purple box captures over 80% of the drops.

Weekly Market Summary

1Q13 ended this week with SPX up about 10% year to date. It is one of the fastest starts to any year and, impressively, follows 12% gains in FY12.

All 9 SPX sectors and the 4 main US indices have been in uptrends for the past 19 weeks (chart). No trend lines have been broken and their 20 and 50-dmas are rising. Moreover, the weekly trend favors equities over bonds. Seasonality is very strongly in favor of equities throughout April. Finally, volatility is very low, a strong indicator of favorable equity performance in the past.

SPX entered an area of strong prior resistance two weeks ago (chart). The 2007 high (1575) and the 2000-07 trend line (1590) are about 1% higher from here. Price action since entering this resistance zone is telling; SPX has been largely alternating direction (up, down) every day for these two weeks and there have been nine overnight gaps. Total gain: 0.4%.

Sector rotation is also telling: in the first half of 1Q, high beta and cyclical stocks led, supported by commodities and ex-US markets and by declining bonds (chart and chart). The second half of 1Q couldn't be more different: high beta, ex-US markets and commodities were all negative; defensive dividend stocks are responsible for the market moving higher. Moreover, treasuries have been equal performers over the past six weeks and led the past 3 weeks (chart and chart). The Euro 350 looks like it has broken trend (chart), following emerging markets (chart).

Breadth is mixed. On the one hand, the advance-decline line keeps marching higher. But the day to day alternation in the market appears to masking distribution (post and chart). We know from 2012 that this can persist for many weeks amidst higher prices, but we also know that price eventually gives way (post and updated chart). Darren Miller has a very interesting alternative way of seeing this (chart).

Seasonality in April, especially during post-election years, has been very strong. But SPX has now been up every month since November. It has not also closed higher in April after that long a stretch in the past 15 years. Put another way, April has been strong partly because at least one of the prior 5 months has provided a dip. That hasn't happened this year (post and an un-updated chart).

Finally, a word about the strong start to 2013. It is true that a fast start in 1Q is, on average, a positive for FY results. But there are two major caveats to this statistic. First, many of those fast starts happened when the prior year was either flat or followed a bear market (1983, 1991, 1993, 1995). Second, in the other years, all of the 1Q gains were entirely given up in 2Q (1987, 1996, 2006, 2010, 2011, 2012). What is the relevance to 2013? It follows neither a flat year nor the bottom of a bear market. Which means, on average, that 2Q is typically rough. That is simply the historical record when you look at fast starts in 1Q next to comparable years since 1980. It doesn't mean 2013 won't end up being a great year. It already is, up 10%. But, betting on all zig with no zag is a low probability event. Read about timing and magnitude here. 

The coming week is the last before 1Q earnings reporting begins (Alcoa in Monday, April 8). 1Q EPS is expected to decline by 0.7% (post). 

What to Expect in April

The best six months of the year are November through April. April is particularly strong, with the Dow up more in April than any other month over the past 20 years and the past 50 years.

Post-election years are particularly strong for April; according to Stock Traders Almanac, April is the second best month for the Dow and the fourth best for SPX. A number of good charts on performance during April can be found here.

So, all is good, right? A few caveats worth keeping in mind:

First, SPX has been up every month starting in November 2012. It has not also closed higher in April after that long a stretch in the past 15 years. Put another way, April has been strong partly because at least one of the prior 5 months has provided a dip. That hasn't happened this year. Since 1980, there has been a 5% dip before April 90% of the time (here).

Second, the post-election pattern is for a weak March followed by a strong April. March in these years is typically one of the worst of the year. Unless something dramatic happens Thursday, March will close up strongly (right now, it is up 3%). This pattern is apparently off.

Third, April has been a key turning point in many years in the past, especially the past 3. Those years bear a strong similarity to 2013. See the chart below. Why is it a turning point? Because April is also the last month before the traditionally weakest 6 months of the trading calendar, a period when bonds have a pronounced tendency to outperform (read here). Trade the trader.

Sentiment Is Not Bearish

There are many debates worth having in the markets right now. The most valuable to us is the apparent strength in US macro against an incredibly weak economy in Europe and parts of the developing world. How this translates into earnings growth, where expectations are very high and yet half come from outside the US, is fundamental to FY13 performance of SPX. There are valid arguments from both sides to be considered.

One debate not worth having is sentiment, specifically questioning whether investors, pundits and the media actually are now bearish equities, meaning, the real contrarian play is to go long(er).

Sentiment works best at bottoms; prices fall quickly, everyone panics and sells. Sentiment studies work nicely here because bottoms are notable events. Tops are much more difficult; prices flatten, the process can take months, during which some become conservative and others stay bullish. This creates divergences (bulls decline while indices move higher) that are harder to interpret. For examples, read further here, here and here.

The first chart is a recent analysis that has led several to conclude that everyone has turned bearish just as SPX and DJIA have reached all-time highs. When the blue line on the chart is high, "too many expect a correction" (like now).

Time To Short Treasuries?

There are three data points you might want to consider before deciding to swing at that pitch.

Short Side of Long (with a new publication I recommend reading, here) uses COT data for small speculators to show that they are already way ahead of you. As a group, they are mega short, which has previously been the signal to look long instead.

Weekly Market Summary

In the past two weeks, SPX has traded in an open/close range of just 1%. The net gain during this time has been exactly zero. Over the past 7 days, SPY has gapped overnight 6 times. And over the past 8 days (including Sunday), ES has alternated direction (up, down) everyday with only one exception. In short, this is a market either changing direction or simply looking for direction.

Since mid February, there has been no net performance differential between SPX and TLT (chart). When you include the higher yield of bonds, equities have underperformed. Moreover, upside has been half of the downside range during this period. This means there has been no reward for risk; in fact, risk (upside)/reward (downside) has been much less than 1. It also implies a divergence has taken place, with equities moving up in the past month as bond yields have sunk (read further here).

None of the 4 US indices nor any of the 9 SPX sectors have either broken their trend line nor made a meaningful lower low over the past 18 weeks (chart). That is a strong trend and, as we have said, this is the most important indicator of the market.

Beneath the surface, however, defensives stocks have, as a group, been leading in the past two months (chart). Cyclicals have been a mixed bag, with some keeping pace with SPX and several underperforming. Andrew Thrasher has shown that high beta has been underperforming low beta, a negative development in the past (chart). Leaders on the way up, Amazon and Goldman, have each lost about 10% within the past two months. Semiconductors (which lead the tech cycle) have gone sideways during this time and have recently broken their trend line (chart). All of these are below their 50-dma.

The implication is that US markets may be beginning the sideways pattern that has been present in the Euro 350, All World Ex-US and Emerging Markets for most of 2013 and from which the US indices have so far been immune. The see-saw action with no net gain and frequent overnight gaps of the past two weeks are typical hallmarks.  To watch going forward is the sideways pattern (chart; explained here).

As it has been since the first week in March, SPX is within a prior area of strong resistance (1555-1575) just as its upward momentum typically begins to fade, (here and here). There is another 1% to the top of the range and an overshot could easily take it 2% higher. Weigh this potential reward against the fact that, since 1980, the probability of a 5% correction by the first week in April is 90% (read here). 1Q13 EPS season begins shortly and guidance has been downward (here and here). To take the market significantly higher, fund managers will need to commit more capital, yet their exposure to equities increased 6 percentage points in the last month and is now the second highest of any period since 2001 (here).

BAML Survey - March

The latest BAML survey of global fund managers shows near-record equity exposure, low levels of cash and the highest exposure to banks since December 2006. The charts are from an excellent post from Short Side of Long (here), a site I recommend bookmarking.

1. "There is a big surge in optimism. The outlook for corporate profits and ample liquidity are keeping investors bullish. In short, investors rotated out of commodities, bonds and cash into equities," says BAML
2. Cash balances remain very low at 3.8% (same as in January and February, vs 4.1% in December 2012). This is the lowest since February 2011. Typical range is 3.5-5%. Moreover, managers are now underweight cash for the first time since early 2011. More on this indicator here and see first chart below.
3. Equity allocations - a net 57% are overweight global equities, a 6 percentage point increase from last month. This is the second highest equity exposure since the survey began in April 2001. In comparison, it was 35% in December 2012. More on this indicator here and see second chart below.
4. Net 53% are now underweight bonds, an increase from 47% in February. This is the lowest weighting since May 2011. Third chart below.
5. 72% expect the dollar to appreciate over the next 12 months, a whopping 30 percentage point increase over last month. This is the highest percentage of bulls in the survey's history. On the flip side, Yen bearishness is the lowest since 2002.
6. EEM had been the most favored region (overweight 43% in February) but this fell to 34% in March. Only 14% expect a stronger Chinese economy in the next year, a massive fall from 60% in February.
1. US is region most want to overweight. Managers are 14% overweight versus 3% underweight in January. 
2. They are the most overweight (15%) Japan since 2007 (versus 7% in February and underweight by 20% in December).
3. Europe was reduced to 4% overweight versus 8% in February and 15% in January
7. Sector weighting reflect risk-on and skepticism over emerging markets.
1. A net 14% globally are overweight banks, the highest since December 2006 (vs overweight 6% in February and net 25% underweight a year ago)
2. Technology is 35% overweight
3. Materials are 17% underweight, reflecting expected weakness in EEM
4. Likewise, commodities are 11% underweight
5. Telecoms are 28% underweight, the lowest in 7 years
8. 61% expect global economy to strengthen next 12 month (59% in February), the highest optimism since April 2010

Read the February and January surveys as well.

Weekly Market Summary

Last week, for the first time in 2013, three positives took place: treasuries were pummeled after outperforming equities all February; Europe and EEM began a move up off of support; and macro data exceeded expectations for the first time since January.

On balance, headwinds seemed to have been reduced and perhaps, therefore, downside (risk) was now lower. But, with SPX within 1.5% of a prior area of strong resistance just when its upward momentum typically begins to fade, it was not clear that upside (reward) had improved (more here and here).

Overall, there were very few changes this week. Your reward for taking on risk this week was to underperform treasuries.

On Thursday, the Dow completed 10 up days in a row for the first time since 1996, but the net gain was the smallest for similar streaks in 113 years. Overhead resistance of significance is likely one reason.

A bigger reason is this: SPX has had at least one 5% correction by May every year since 1996. Since 1980, the probability of a correction by the first week in April is 90% or more. The current uptrend is running headlong into an exceptional bias (read here).

Long winning streaks like the Dow has had appear to be a sign of strength. Indeed, when they take place after a long consolidation or drop, they have definitely been followed by excellent returns. But when, as now, these streaks have occurred after a long uptrend, they have typically been followed by flat to poor returns. That is the historical record (read here). 

SPX ended the week for the first time within the 1555-1575 resistance zone. It continues to follow the pattern from 2011 very closely: rising 7 weeks in a row, then a 1-2 week consolidation, followed by a further 3 week rise. There is another 1% to the top of the range and an overshot could easily take it 2% higher.  Weigh this expected return against expected risk.

The final point is on valuation: at SPX 1560 and assuming consensus EPS of $110 is correct, the SPX is valued at 14.2x which is the exact 10 year average. But quarterly EPS has been flat for 6 quarters and is expected to remain so in the current quarter. If FY13 EPS is even $104 (equalling 7% y-o-y growth), then the PE is already at 15x. This is the top of the recent range (read here). The next earnings season should be watched closely.

There's More Than a 90% Probability of a SPX Correction Before April

That's a Business Insider-type title. Have to grab you.

We have been anticipating strong resistance between 1555 and 1575. SPX is now trading 1% off the top of this range. As Ryan Detrick points out, the past 10-day-in-a-row-advance in the Dow is the weakest since 1990. We think the SPX resistance zone is likely a main reason. 

Another reason is timing. SPX has had at least one 5% correction by May every year since 1996. 

The same can be said about every year since 1980, with only 3 exceptions: 1985 (it corrected in June), 1989 (September) and 1995 (none). Those exceptions bear no resemblance to today as the prior year in each case was either flat or strongly down and demand was therefore pent up. Last year, in comparison, SPX rose 12%.  In the first chart below (zig zag 5%), those exceptions are shaded yellow. 

The key is this: excluding those years, SPX has had at least one 5% by the end of March 93% of the time since 1980. If you include the first week in April, the probability rises to 97%. Even if you include those other years (1985, 1989, 1995), the probability is 88%. The current trend is running headlong into an exceptional bias. 

Time to Get Long the Dow?

The record setting pace in the Dow is grabbing headlines. On Tuesday, it closed higher for an 8th day in a row. On Monday, it closed above its upper Bollinger Band (BB) for a 5th day in a row. Time to get long the Dow?

The first chart looks at the Dow on a weekly basis since 1997. Over those 16 years, the weekly RSI (5) has closed over 90 only six times (marked in yellow). It closed recently at 92. Momentum tends to fade at these levels. The smallest subsequent drop was 5% and several where considerably larger (over 20%). In the best case, price moved sideways for next 6 months or longer.

Weekly Market Summary

The storyline last week was this: the trend in US indices and sectors was up but showing fatigue, with cyclicals lagging; the trend in ex-US indices, currencies and key commodities was lower and a concern, and treasuries were confirming these concerns; breadth was signaling distribution; volatility was picking up; and macro expectations were headed lower. All of this, with overhead resistance about 3% higher, and, bottom-line, the risk/reward did not seem even close to being 1:1.

This week, for the first time in 2013, three positives took place, and they are reflected in the summary chart below (see arrows). First, treasuries were pummeled. Second, Europe and EEM began a move up off of support. Third, macro data exceeded expectations.

All things equal, headwinds seem to have been reduced and perhaps, therefore, downside (risk) is now lower.

It is not clear, however, that upside (reward) has improved: the monthly and weekly charts suggest SPX is reaching (within 1.5% of) a prior area of strong resistance just when its upward momentum typically begins to fade (more here and here).

Macro Surprises Have Become Favorable

In the past week, macro surprises in the US have been favorable. As a result, the Citigroup Economic Surprise Index (CESI) has crossed back above zero after having been negative from late January.

There is an exhaustive post on what this Index means here. This is the bottom-line: According to JPM, the last 7 times that CESI went negative, over the next 3 months, the $SPX had average upside of just 1% versus an average downside of 8%.

No one indicator is perfect; there is a clear possibility that CESI sent a false negative in January. The downward trend in EPS revisions and global macro data (all detailed here) would seem to make this unlikely, but you never know. For now, we will give CESI the benefit of the doubt and assume that the trend is higher.

A word of caution: CESI crossed negative in late 2009, made a shallow dip, then turned positive again at the end of the year. See green arrow in first chart below. It turned to be a fake out. In January 2010, CESI went negative a second time and SPX dropped 9% (second chart). Prudence therefore suggests giving time to confirm the recent move back above zero.

How Much Do Bonds Lead Equities

Last week, SPX rose all 5 days. It has, in fact, risen the last 6 days in a row. Bonds, which had outperformed SPX through February, were slaughtered, closing at their lows for 2013 on Friday. $TLT closed in its lower zone on the weekly chart and on its lower Bollinger Band on its daily chart. Many pundits think this signals the all-clear for SPX.

Yields rise (bond prices fall) when investors believe the economy is rebounding. 10 year yields rose 200 basis points between 2003 and 2006, during which time SPX rose 80%. On this basis, the fall in $TLT is a plus.

But US 10 year yields are just 2.05%. The UK, whose economy has stagnated in the past two years, has the exact same yield. Putting it in perspective, the bond market is hardly ascribing any growth to the US economy.

Moreover, bond prices have an asymmetrical relationship to SPX: rising bond prices (falling yields) are often a warning for equities, but a drop is not necessarily benign.

See the chart below; the width of the yellow shading is the time between the bond price low (blue line) and equity price high (black line). A wide yellow band means that there was a few weeks lead time between bond prices starting to rise and SPX starting to fall; a narrow band means that there was next to no time lead time. 

In the past three years, sometimes bonds have given a few week lead time warning to SPX; several times there was no lead time warning at all. In 2011, $TLT hit a new low in early February; SPX dropped 7% over the next month.

Does Prior Resistance From 2007 Matter Anymore?

$SPX is now within a few points of its prior tops in 2000 and 2007. Will this matter?

Probably. Look at how RUT, COMPQ and SPXEW reacted and then look at the charts for SPX and INDU.

In any case, the next few weeks will provide the answer.

Placing the Current Rally In 10 Year Perspective

The chart below looks at rallies in SPX over the past 10 years that have lasted more than 3 months and have risen more than 5% (it's a zig zag chart; every change in direction requires a >5% move). Every correction (red shaded areas) is also at least 5%, and we've made the width of the shading equal to 3 months.

1. The current rally has now risen 16% (chart has not been updated since Wednesday) over nearly 4 months.  
2. This places the current rally now 1 percentage point shy of the average gain and 2 percentage points shy of the gain from the rally that kicked-off 2012. 
3. Time-wise, the current advance is of average length (although some have been twice as long). It is longer than the one from early 2012.
4. Most of the corrections have been 1-2 months in length before a 5% bounce.

Net, the current rally is hitting the average for length of time and gain. Bear in mind as well that today, with SPX's high at 1551, it is within 0.2%-1.5% of the expected resistance area (1555-1575) on the monthly charts. Read further here. 

How 2013 Is A Dead Ringer For 2011

2011 started strong and ended up dead flat. This was a surprise because it was up nearly 7% through February. Investors were bullish, and the trend was higher.

After February, SPX only rose 1.9% higher (May) during the rest of the year. For 5 months (March-July), SPX traded sideways in a 10% band. Risk was therefore 5x reward during this period. In August, SPX plunged 20% (risk 10x reward). The October 2011 low, with its accompanying washout in sentiment, set up the 12% rise in SPX during 2012.

It is worth pointing how similar the current set up now, in 2013, is to early 2011. The end result may turn out differently, but the similarities are at least noteworthy.

In The Aftermath Of Long Winning Streaks in SPX

In writing Thursday's post on the similarities between 2013 and 2011, I came across these analogues. In the past 20 years, SPX has risen 7 weeks in a row three times (2007, 2011 and 2013) and 8 weeks in a row three times (1997, 1998 and 2004).

In the charts below, the green arrow is the year leading into the strong winning streak. The yellow box is the period that immediately followed.

What Lies Ahead (or Above) For SPX

With the DJIA making an all-time high today, what lies ahead for SPX?

Monthly: The first chart is a 16 year monthly view of SPX. The green band is ~10% wide with a top at 1555, less than 1% from where SPX is today.

SPX first rose to 1553 in March 2000 (first green arrow). Note that traded in a ~10% range the next 8 months. Interestingly, seven years later, SPX rose to nearly the exact same level, reaching 1555 in July 2007 (second green arrow). And, just like in 2000, SPX once again traded in that ~10% range for 8 months. This is an area, in other words, with a lot of trading activity and, apparently, strong resistance at the top of the range.  Only one month after reaching 1555 in 2007, SPX lost 12% (red arrow).

SPX went on to make a new higher high 3 months later in October 2007 at 1576 (blue line).  Based on the past trading history, we should expect resistance in the 1555-76 area and be prepared for the potential for a wide, volatile trading range.

A Breath Warning From SPXA50R

There are a number of good ways at looking at breadth. One is discussed below. It is the percentage of the S&P 500 trading above its 50 day moving average (dma). On Stock Charts, the symbol for this is SPXA50R.

The concept is simple: rising prices on SPX should be accompanied by a greater number of companies trading above their 50-dma. In the current uptrend, more than 90% of the SPX were trading above their 50-dma in late January. There was no divergence between breath and price.

Since then, SPX has made new highs while the number of companies above their 50-dma has fallen to 74%. This is a negative divergence.

Sometimes, price and breath peak together; at other times, breadth leads and gives a warning about the deteriorating underlying quality of the advance.

In the chart below, we have plotted a smoothed SPXA50R (red line) against SPX (blue line) since 2007. The divergence between breath and price can last 1 month (in rare cases, 2 months) but the result is the same, with a decline in SPX of 5-10% to follow (some were more).

In the present case, SPXA50R (as calculated; see notes below) has been declining for 3 weeks. The time for a corresponding move in SPX is within the next few weeks, but typically earlier.

Weekly Market Summary

Last week we noted: (1) SPX had broken down through its 2013 trend line; (2) defensives were outperforming cyclicals; (3) ex-US indices, currencies and commodities were breaking much lower; (4) treasuries appeared to have broken above their downtrend; and (5) breath was signaling distribution. 

The bottom line last week was this: strong uptrends do not typically end abruptly and we would expect, based on past performance, for the indices to make at least one higher high. But, the risk/reward is becoming much less attractive. 

The full text and chart is here.

Which bring us to this week:

1. As expected, SPX made a higher high on a closing weekly basis. 
2. But, risk was 2.1% downside versus a return of 0.5% upside and a net gain of 0.1%. Risk, in other words, was 4x larger than return. That's poor.
3. Trend:
• All the US indices and sectors made lower lows this week. All made lower highs as well, except DJIA.  
• Ex-US indices continue to decline under their 50-dmas. The euro, aussie, oil and copper ended the week on new lows. These are serious divergences with US indices.
• Treasuries confirmed last week's break above their down trend. TLT is now back in its upper trading zone. Treasuries are acting in concert with ex-US indices, commodities and currencies. The correlations are all working, excepting US indices.
4. Breath deteriorated further with a second 90% down day this week and no offsetting 90% up day. 
5. Volatility exploded 34% higher on Monday: 
• The historical implication within the next few days are for higher prices in the indices, which we have now seen. 
• Over the next one to four months, the historical tendency is for downside to SPX, with a typical pullback of more than 5%. Think of this as one measure of risk going forward. Read more here, here and here. 

Ex-US Indices, Commodities and Treasuries Divergence With SPX in February

We have previously noted the importance of cyclical sectors leading the advance (here) and the correlation of US indices with equities in the rest of the world (here).

The advance in January was supported by cyclical sectors as well as key commodity groups and ex-US indices (first chart).

The choppier advance in February was supported by neither cyclicals, nor commodities nor ex-US indices (second chart). These divergences do not typically persist. The outlier is clearly the US indices; the others are all in agreement and supported by the decline in treasury yields.

Charts below.

FY13 EPS: Growth Expected Where There Has Been None

With 97% of 4Q12 earnings in the book, S&P has FY12 EPS at $97, a 0.5% increase over FY11. For FY13, consensus bottom-up is $112 and top-down is $108. That works out to 11-15% annual growth. Their data is here.

To make matters more interesting, FY13 is not getting off to a good start: Factset reports that 77% of the companies issuing 1Q13 guidance, issued negative guidance, the highest rate of negative guidance since they started tracking in 2006. More to the point, 1Q13 EPS is expected to come in 0.4% lower.

In the first chart below, the 11-15% growth in FY13 EPS all comes after 1Q. What is impressive is EPS will have not grown at all in the prior 7 quarters.

Relatedly, year over year GDP growth this week was reported to be just 0.1% higher in the US; in Europe, it was 0.9% lower and the continent is officially in recession. Recall that half the earnings for $SPX is from overseas.

Despite this, SPX companies expect more than 3% growth in revenues. Which means that the growth in earnings is primarily margin expansion. But, as GS explains, margins have actually contracted four quarters in a row (second chart). Consensus nonetheless expects margins to expand to their highest ever.

Charts below.

What To Expect in March and April

The strongest 6 months of the calendar run from November through April. November through January is traditionally the strongest 3 month stretch of the year.

February is the weak link in the 6 month chain. Seasonal strength returns in March and April. 

In the first chart (from SentimenTrader), you can see that March and April are up 65% of the time on average for 1 to 2.6% gains each month. 

The second chart (from David Stendahl) shows March and April are strong whether viewed over the past 5, 10 or 15 years. Adding granularity, March seems to start weak and then rip from mid-month onwards.

The potential fly in the ointment is that in post-election years, March is weak (see third chart). As Stock Trader's Almanac says: "In post-election years, March ranks 5th worst for DJIA, S&P 500 and Russell 2000. NASDAQ is 4th worst. In 10 post-election years since 1973, NASDAQ has advanced just four times in March."

Getting too granular or literal on seasonality is not a great investing approach in the absence of other confirming factors. That said, April is typically solid, and if March presents a nice dip, seasonality is a tailwind on the long side (see fourth chart). 

Charts below.

What Monday's Jump in VIX Means For SPX

On Monday, VIX jumped to 19, an increase of 34% in one day and 55% over the prior week. What does this imply for SPX?

We have previously noted that VIX was, like today, in a period where it was sub 20 between 2003-07. Overall during this time, returns for SPX were mostly very good. However, VIX would occasionally jump 50-80% higher and $SPX would decline more than 5% over the next 1-4 months. We are potentially repeating this pattern now. 

In the first chart below, we have updated the chart from 2003-07. The bottom panel shows VIX moves of greater that 30%, of which there were 9. In the top panel are corresponding moves in SPX. The percentage drop in SPX is noted in the text. 

In the second chart, we have done the same analysis from 1992-97, also a period of low volatility. The conclusions are the same, with corresponding pullbacks of 5-10%. 

Sellers Are In Control

This is a follow on to last week's post on the first major distribution day (MDD) since November (read it here). Recall that a MDD occurs when down volume is more than 90% of total volume on the NYSE.

At the time, we postulated that (1) an MDD the day after a new high in $SPX portends further downside, and (2) that a cluster of MDDs would indicate sellers are in control and lower prices will prevail. Sure enough, yesterday a second MDD hit the market that knocked out all the gains in the indices from over the past month.

Today, all 4 US indices and 6 of 6 cyclical SPX sectors are below their 20-dma. Watch the slope of those averages; the rest of the world has led the US markets, and their averages are now down sloping (see first chart, below). The US appears to be in the process of resynchronizing with those markets (second chart).

For at least the short term, sellers are in control of the market, and will remain so until one or both of the following transpire:

1. US indices and a majority of the 6 cyclical sectors on the SPX regain their upward sloping 13-ema (or 20-dma), showing that the trend remains higher and is being led by economically sensitive stocks.
2. Breadth swings forcefully in favor of bulls. In the third chart below, you can see that in the past, following a cluster of MDDs (red bars, bottom panel), the rebound only took hold when up volume exceeded 90% - a major accumulation day (MAD; middle panel with the green bars). Strong positive breath pushes a large number of stocks higher. With some follow through, $NYMO will also turn positive and $NYSI will regain its positive slope. An intervening distribution day obviously puts the ball back with the sellers (see May-June 2010).

Again, for the time being, sellers remain in control. Charts below.

Bullish Sentiment Declines Ahead of Price

Last week, $SPX made an uptrend high (1530). During the past few weeks, bullish sentiment as measured by AAII, II and NAAIM, has declined from their early February peaks. Many pundits have pointed to the declining number of bulls as a sign of further upside in price. Is it?

Historically, the answer is no. Bullish sentiment tends to peak ahead of price and then decline, making a negative divergence. Thus, the recent decline in bullish sentiment is consistent with the later stages of an uptrend. Bullish sentiment typically peaks when AAII is over 50%, II is over 35% and NAAIM is over 80%. AAII and NAAIM have recently exceeded those levels; II came close (32%).

The later stages of an uptrend are difficult. The trend is higher but becomes rounded as some investors become cautious ahead of others. Bottoms tend to be capitulative, with sentiment and price in sync.

Here are the charts:

Weekly Market Summary

The weekly market summary allows us to track the market's narrative as it changes. The story so far has been a 4 month uptrend, recently capped by a 7 week streak of higher closes. Uptrends do not typically end abruptly with that type of strength.

At the end of January, some of the secondary indicators started to move from 'tailwind' to 'headwind'. Sentiment (measured several ways) became exceedingly bullish. Then, macro data started to disappoint versus expectations. Both of these often lead price.

In the past two weeks, three new headwinds developed. First: actual $SPX earnings implied flat growth in FY13 versus expectations of growth of 10%. Second: markets outside the US, in both $EEM and Europe, declined and closed under their 20-dma. Third: breadth in US markets narrowed as price rose, creating a bearish negative divergence.

Which brings us to key changes this week:

1. Trend: This is the most important factor in the summary and for the 13th week out of the past 14, a majority of US indices/sectors closed >13 ema. However, the trend is weakening. You can see two trend downgrades on the summary chart below.
• $SPX, our focus, closed under its 2013 trend line this week. 
• Moreover, half of the 6 cyclical sectors closed <13 ema. In February, defensive sectors are leading the market, a bad sign. 
• Cyclicals appear to following ex-US markets, which continue to weaken further. This week, $DAX, $HSI, $SSEC and $EEM, together with $6A, $6E, oil and copper, all closed < 50-dma. All of these correlate well with US indices. 
• Bonds, which have based during the past month, closed near a monthly high and > 13 ema; something to watch this week.
2. Breadth: This is the second most important factor and we have noted that $NYSI has been slowly declining. This week, however, a day after a new high in indices, the market experienced its first 90% down day since November; a major distribution day (MDD). When these occur at new highs, selling momentum normally carries over.  Read further here.

The bottom-line is this: US indices and sectors are, for the most part, still trending upwards and, again, strong uptrends like this do not typically end abruptly. We would expect, based on past performance, for the indices to make at least one higher high. If you like patterns, think of a 'head' or 'right shoulder'; if you prefer waves, think of a 5th of 5 wave uptrend. But the trend is weakening and most of the other factors are now headwinds to further appreciation.  

As a result, the risk/reward is becoming much less attractive. You could swing and hit the ball, but it will be low and outside, not a fat pitch.

The next area of resistance, from the 2007 peak, is 2% away (reward). Meanwhile, a 38% retracement and the 50-dma are 3% below (risk). In January 2011, $SPX rose 7 weeks in a row and then experienced a MDD, just like this week. Over the next year, upside was a further 5% (reward) while downside was 12% lower (risk). 

This week, among other things, look for whether cyclicals and ex-US markets change behavior or continue to underperform. Also, a second MDD would be a major watch out that sellers are taking control. Finally, watch whether Mr Bond can move above its recent base. All of this while the sequester approaches.

What Today's Major Distribution Day Means for $SPX

Down volume on the NYSE was over 90% of total volume today, an event known as a major distribution day (MDD). This is a measure of breadth; recall in the weekly market summary that breadth is second after trend in importance, so a MDD is of significance.

Today's MDD was the first since the mid-November low in $SPX. A few points:

1. Yesterday, SPX formed a new high. Today, all those gains were given back on trading dominated by sellers. This, in the past, has been a bad combination. See the first chart below (red arrows). Selling momentum typically carries over into the following period. 
2. Today's set up is eerily similar to April 2010 and February 2011. See the first two red arrows on the first chart: a long, grinding uptrend capped by a MDD. April 2010 double topped within a week; February 2011 began a multi-month topping process. Either one of these is a possibility.
3. Not all MDD's are the same. After a downtrend, an MDD can mark the point of capitulation. See the second chart below (green arrows). This was the case at both the June and November lows in 2012. 
4. Some MDDs are rogue and some come in clusters. See the red rectangles at the bottom of chart three. It should not be a big surprise that a cluster of MDDs will lead to a substantial decline in $SPX. We have to be on watch now for another day like today.
5. Finally, today is day one of major selling in 2013, and its coming after a 7 week uptrend. Long uptrends like that, in the past, have not ended without at least a second attempt at the recent highs. Read further here and here.