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. 

Friday-Monday Effect During $SPX Trends

There is a good correlation between up trending markets and a positive close on Fridays. Since the start of May through today, down weeks almost always end with a down Friday. The reverse is also true: up weeks end with an up Friday about 75% of the time. In the chart below you can easily see the correlation.

Another effect is also taking place: Fridays and Mondays tend to alternate direction. Thus, over this period of time (n=42 weeks):

1. When Friday is up (n=25), Monday is down 75% of the time.
2. When Friday is down (n=17), Monday is up 65% of the time.

In an uptrend, beware of down Fridays. 

Even more so, in a downtrend, look for a strong close on Friday for a possible start to a reversal.

Impact of Weakening Global Macro on SPX

Part of the value in the Weekly Market Summary is to place different factors into perspective. Negative macro or sentiment are individual factors and not even the most important ones. Bear that in mind while reading on.

Macro developments in Europe and the rest of the world are worth noting, especially when weakness is creeping in while investor sentiment in the US is very bullish. A few points:

1. Global equity markets tend in the same direction. So note, EEM has diverged since the start of January and Euro 350 since the start of February. Both are down 3-4% from their high while $SPX has moved up. Both are toying with their 50-dma while $SPX is 3.6% above. Germany's $DAX is now below its 50-dma. Charts here.
2. This relationship makes sense. About 50% of $SPX earnings comes from outside the US. Europe's economy is about the same size as that of the US (both about 20% of the total). 
3. Moreover, Eurozone and US production are correlated. They can decouple but those periods do not generally persist. See first chart below. The point is, Europe is not some sideshow for US investors.
4. Half or more of OECD economies may now technically be in recession. See second chart. A recession is defined as either one or two consecutive quarters of economic contraction. The dip in the number of economies with positive growth is the first severe one since early 2008. 

Final point: this is coming at a time when S&P earnings has apparently declined the past two quarters (see here).  Factset has reduced 1Q13 earnings growth to negative 0.04% from 3%. 

Pay Attention to Citi Economic Surprise Index

On January 25th, the Citi Economic Surprise Index (CESI) crossed through the zero line and became negative. To be sure, no single factor predicts all changes in equity prices. But, you want to pay attention to CESI, especially if other factors start to point in the same direction. 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%. That's poor risk/return.

A few key points:

1. In the past, a negative CESI has led a decline in $SPX. In the first chart below, the yellow areas are where CESI turned negative since 2007. $SPX (blue line) followed each time, losing 8-10% or more each time. There was a two month lag in mid-2011 where $SPX stalled before a large correction. 
2. Part of this correlation relates to EPS revisions (second chart). JPM points out that when CESI heads lower, EPS estimates are typically revised lower. And vice versa. 
3. Another part of this correlation relates to valuation. When CESI heads lower, PE ratios typically also contract, and vice versa. 
4. A final component to this correlation is that bond yields move with macro expectations. When macro disappoints, yields head lower and bonds outperform equities (third and fourth charts). 
5. When CESI is -90 or lower, macro expectations have often bottomed (fifth chart). 

Charts below the break

Weekly Market Summary

Our overall market view remains positive, but with reservations. The trend is up: for the 12th week out of the last 13, a majority of indices/sectors closed >13ema. This week: all 4 US indices and 9 of 9 SPX sectors. TLT is still below all its MAs.

For the second week in a row, several ex-US markets have been <20-dma and diverging with US, including Euro 350, DAX, EEM and All World Ex-US. Euro and Aussie currencies are also weakening. $USD closed at its high for 2013. The US will resynchronize with the other markets.

Breadth is also in neutral for a second week in a row with NYMO oscillating at the zero line. NYHL continues to diverge, lower. Again, these divergences can persist for a month or so. But, unless corrected, these are likely to be late stage signals.

One change this week is a downgrade to Valuation. S&P data shows a second sequential decline in quarterly EPS growth. Overall 2012 growth may be just 2%. To be conservative, a lower forecast for 2013 is warranted, putting PEs near 15 and above average. 50% of SPX earnings are foreign, and Eurozone GDP growth is now negative; another headwind.

Sentiment and macro expectations remain the headwinds as well.

Sector Rotation: Watch for Weakness in Financials and Discretionary

We look for patterns in the nine $SPX sectors every week as a tell for overall market direction. Yes, it's part of the Weekly Market Summary. For example, in autumn 2012, when $SPX fell for two months into November, the fact that financials and consumer discretionary had so strongly led the advance gave confidence that the market would continue higher.  And it has.

The charts below review how sectors performed on a relative basis through the past 10 years, a period that includes at least a cycle and a half. 2013 is off to a good start, but its been a mixed bag, with defensives up with cyclicals. As explained below, watch for weakness in consumer discretionary and financials combined with strength in utilities as a sign of a trend change. Not yet. 

Exuberance in Junk The Past 3 Times Was Bad for $SPX

Further to our junk bond exuberance post on February 6, we wonder: what happened to $SPX the last three times junk bond prices traded at these levels (in 2004, 2005 and 2011)? The answer is: all three times, the advance in equities stalled and declined, the most dramatic being early 2011. Charts below the break.

Put-Call Moves Opposite To Indices

One of the "sentiment" measures in the Weekly Market Summary is the trend in the put-call ratios (CPC - total; CPCE - equity only; CPCI - index). Lawrence McMillan of the Option Strategist makes an interpretation each Friday. Read his weekly commentary here.

He uses a 21 period MA. You can also look for a pattern of highs and lows. To wit, when CPC is falling (less put protection, fear receding), $SPX typically rises. See the first chart:

Valuation and Macro Are Correlated - And Out of Sync

With the Citi Economic Surprise Index (CESI) going negative in late January, there is reason to be concerned about the forward PE valuation on $SPX.

The chart below is from February 2012 (last year). You can see that over the prior 5 years, there was a high correlation between CESI and valuation; when economic measures exceed expectations, multiples expand, and vice versa. This is what you would expect. (In this case, by the way, the $SPX rose 5.5% over the next 2 months; the blue line caught up with the red one).

Fund Managers' Current Asset Allocation - February

The latest BAML survey of global fund managers continues to show high levels of risk-on positioning with low levels of cash (3.8%) and the highest global exposure to banks since early 2007.

1. “The continued high level of optimism is a concern and markets may be vulnerable to bad news, but valuation support suggests any correction should be short and shallow" says BAML
2. Cash balances remain very low at 3.8% (same as January, vs 4.1% in December 2012). This is still lowest since February 2011. Typical range is 3.5-5%.
3. Equity allocations - a net 51% are overweight global equities, same as January (and the highest since February 2011). It was 35% in December 2012.

$112 FY13 EPS Looks Like a Stretch

As companies continue to report, an unwelcomed truth has been uncovered. F13 EPS has been expected to top $112/share. This would represent 10% growth over FY12 EPS of $102.

There are two problems: first, FY12 will likely to be closer to $98-100. This is just 2-4% growth over FY11 ($96.4) - nowhere near 10% expected this year. Which brings us to the second problem: even if growth is again 2-4%, FY13 EPS will be $100 to $104.

Earnings expectations being 8% or more too high at a time when investor sentiment is at a bullish extreme is not a good combination.

Final point: 3Q12 EPS was lower than 2Q12, and 4Q12 is on pace to be lower than 3Q12. That's two consecutively lower EPS numbers. This has never happened outside of a recession.

BAML Bull/Bear Index at Bullish 99th Percentile

BAML's Bull & Bear Index of investor sentiment toward risk assets is at a more bullish level today than 99% of all readings since 2002. The current reading is 9.6 (out of 10). Since 2002 a "sell" signal of >8.0 was on average followed by a 12% peak-to-trough correction in global equities within three months.

Duration of Sequential Up Weeks

In a follow up to the prior post on uptrends, Thomas Bulkowski has some useful statistics. Over the past 10 years, greater than 7 up weeks sequentially has a 2% probability of continuing; greater than 6 up weeks, a 5% probability; greater than 5 up weeks, an 8% probability; greater than 4 up weeks, a 16% probability.

Some Key Ex-US Indices Diverging from $SPX and $DJIA

Global equity markets tend in the same direction. The first chart below on weekly timeframe, comparing $SPX to $EEM, Euro 350 and All World Ex-US, makes this apparent. 

So, when divergences become apparent, it is at least a flag. In the second chart on daily timeframe, EEM has diverged since the start of January and Euro 350 since the start of February. Both are down 3-4% from their high while $SPX has moved up. 

What Happens After the Largest In-Flows Since 1996?

The last time in flows into equity mutual funds and ETFs was as large as last week's was January 1996.  The situation is remarkably similar to today: a strong run up in the market several years after the end of the economic recession. The start of the new year is strong as well. The good news about the market is featured on the front page of the Times and Barron's. Retail investors want to get involved.

This is what happened next:

US Sector Trends: Very Strong But Some Cyclical Weakness

Every week in the Weekly Market Summary, we comment on the trend of US indices and 9 $SPX sectors. Our benchmark is maintaining above a rising 13-ema. Below that raises a flag. Turning the slope negative or losing the 50-dma raises an alarm if it is widespread among sectors.

In the past two weeks we've seen some cyclicals not make new highs with the indices and also relative outperformance by defensives. These are worth watching closely.

Weekly Market Summary

Our overall market view remains positive. The trend is strong: for the 11th week out of the last 12, a majority of indices/sectors closed >13ema. This week: all 4 indices and 9 of 9 sectors.

Two cracks are starting to form in trend and breadth, however. Several ex-US markets are now <20-dma and diverging with the US indices. Within breadth, $NYMO is struggling at the zero line and $NYSI is diverging. This is just like February 2012. $NYHL is also diverging, moving lower while indices move higher. These divergences can persist for a month or so. But, unless corrected, these are likely to be late stage signals.

Sentiment and macro expectations remain the main headwinds.

Breadth Divergence Watch

One of the two main drivers of the Weekly Market Summary is breadth. It has been unmistakably strong since the November low. The chart below looks at $SPX in the top panel versus NYMO (middle) and NYSI (bottom). 

Generally, weak breadth (NYMO below zero) leads to weak prices. See September-November 2012 as an example. This week, NYMO returned below zero. If the stay is brief, then there is no problem. If this persists, NYSI (bottom) will start to fall and price usually follows. 

Note the long negative divergence between NYSI and price between February and March 2012 (yellow arrows). Eventually, it resolved to the downside with a 10% correction in $SPX. 

Insider Selling 9:1 - A 2% Correction Usually Follows

Ironic, in my opinion, that insider selling is at a high the same week as newletter writers recommend their longest exposure in 13 years. This is people with inside information versus those without.

Mark Hulbert: "The sell-to-buy ratio for NYSE-listed shares listed now stands at 9.2-to-1. The last time a weekly sell-to-buy ratio was worse than this was in late July 2011. Over the next couple of weeks, $DJIA lost some 2,000 points. On average over the month following each prior occasion when the sell-to-buy ratio got this high, the broad market fell by 2.1%. " 

Read the full text from MarketWatch here

All-Time High Newsletter Sentiment: Poor Returns Next 1-6 Months

From the excellent site SentimenTrader:

“The survey of investment newsletter writers from Hulbert Financial Digest is theoretically better than most, since it focuses on actual trading recommendations instead of sometimes-ambiguous opinions.”

“There have been a total of 9 weeks when the combined level neared 70% (a couple of them were clustered together).  A month later, the S&P 500 showed a negative return every time, a median of -3.1%.  Its maximum gain during the next month averaged only +0.1% (using weekly closes) while the maximum downside averaged -4.4%.

Even over the next six months, returns were poor.  Only 1 of the 9 weeks had a positive return (+1.9%), and the median was -4.25%.  The most that the S&P rallied during the next six months averaged only +0.7%, while its maximum decline averaged -13.8%.”

Junk Bond Extremes

Junk bond exuberance seems to be extreme:

1. The effective yield on junk bonds is now around 6%. This is an all-time low. During good times, the normal range is about 7-9%. See first chart below the break.
2. Part of this is explained by the low default rate of about 3% versus an average of 4.8%. Note, however, that the default rate a year ago was 2.3%. It's creeping up.
3. On a relative basis, these yields seem extreme. Oscar Schafer: "High yield bond yields are lower than the S&P's earning yield for the first time ever." 
4. Loomis Sayles’s Matt Eagan: "High yield bonds don’t typically trade at higher than par plus half their coupon." David Schawel: "Well, guess what? We are at that place today." Read his excellent take here.

Low Vix Means 5% Corrections Are Few And Far Between

In the past 20 years, there have been two long periods where $VIX was mainly below 20. During both of these periods, 5% corrections were few and far between. The chart below shows only changes in direction of >5%. Some observations:

1. Uncorrected uptrends during these times can last 4-12 months. 1995 went a full year. There are several lasting more than a full quarter. Low volatility has meant higher prices, long bull runs and shallow corrections.
2. The two periods ran from 1993-97 and 2003-07. A third period may be starting now, in 2013. Is this a 10-year cycle, lasting 4 years?
3. 1993 and 2003 came after economic recessions that corrected the market. We are now already in the 4th year of an uptrend. The starting point for this third era is very different.

Duration of Uptrends Since March 2009

Since the March 2009 low, there have been 8 discrete and completed uptrends. Some features:

1. Median length of 12 weeks, mean duration of 12.4 weeks, minimum duration of 10 weeks, maximum duration of 16 weeks.
2. 4 up weeks in a row is common. 6 has been a typical maximum. One was 7 weeks (2011). The current uptrend has completed 6 weeks.
3. Within an uptrend, it is common to have 2-4 red weeks. Overall, about 70-80% are up weeks.

Importantly, after a long uptrend up more than 5 weeks, the down week is usually minor (within the low of the prior week) and there is always a higher high ahead. Strong trends do not end after a long streak of up weeks.

Graham-Shiller PE10 At 85th Percentile

Doug Short (link) has a valuable post on the cyclically adjusted price-earnings (CAPE) of $SPX. Using smoothed earnings (average of the past 10 years) and smoothed price (average over the past month), $SPX is valued at 22 times versus a long term average of 16.4. This is in the top 85th percentile of all periods since 1871. In other words, its overvalued on this methodology. See the charts below the break.

The purpose of using 10 years of earnings is to reduce the volatility of a trailing PE due to the cyclicality of earnings. Because of this, however, over- and under-valued can persist for years. So, this is back pocket material and not useful for timing except, perhaps, at enormous extremes.

You can get a daily update here

Typical Topping Pattern: Not There Yet

Take a look at recent topping patterns as they are fairly typical. There's two steps to each:

1. Green arrows: After a long run, momentum starts to weaken and price tests a key trend line or moving average (here, its the Bollinger mid-band). 
2. Yellow area: Price pushes higher, falters, tries a third time and makes a double top (or lower high).

Look at where $SPY is now. It has not even tested a key moving average yet (part1). When it does, buy the dip and expect price to move higher before making a discernible topping pattern. If nothing else, look for an actual lower low before expecting a top to develop.

Update on Nasdaq and Newsletter Sentiment: They're High

Two more extremes in sentiment published today.

1. SentimenTrader and Hulbert measure Nasdaq investor bullishness at the highest level in 8 years. 
2. MarketVane measure newsletter bullishness at the same extreme as prior peaks in $SPX in March and September 2012, as well as the peak in June 2007.

Nasdaq Negative in February Every Post-Election Year Since 1985

Stock Trader's Almanac has this to say about February:

1. Since 1950, January $SPX gains of 2% or more corrected or consolidated in February 67.9% of the time. 
2. In the 19 years that $SPX gained 4% or more in January, 68.4% of the time it declined or finished flat (less than 1% gain) in February. 
3. February’s post-election year performance since 1950 is miserable, ranking dead last for DJIA, $SPX, NASDAQ, Russell 1000 and Russell 2000. 
4. NASDAQ has not posted a post-election year February gain since 1985.

Sentiment is Heady and Out of Sync With Macro

National Association of Active Investment Managers (NAAIM) went 104% long equities this week. This is the highest percentage long in the 7 year history of their survey.

Over 80% is generally overly bullish and above 90% was last seen run to the 2007 SPX top. Moreover, the most bearish manager in the survey is now 60% net long equities, the most bullish position in the history of the survey for the most bearish manager. 

What happens next? Most likely is a pause or pullback. Not a major top. Yet. You should notice with all sentiment surveys that bullish (or bearish) extremes lead price. They normally begin to decline as price heads higher (divergence). A decline in sentiment as price heads higher should be a watch out. For now, note one more sign of exuberance.

Weekly Market Summary

Our overall market view remains positive. There were no changes in our model this week: trend and breadth remain strong while sentiment and macro expectations remain headwinds. As we have said, trend and breadth are the main drivers; the others are headwinds, tailwinds and tea leaves.

Trend: the 10th week out of the last 11, a majority of sectors and indices close >13ema. This week: all 4 indices and 9 of 9 sectors.