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?

Fund Managers' Current Asset Allocation - 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.