Saturday, May 18, 2013

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.