Weekly Market Summary

After the sharp V-bounce in July, the risk-reward for US equities in August was to the downside (post).

For bonds, it was the reverse (i.e., to the upside; post).

Indeed, the Dow, which has been leading, will end August being down 4 weeks in a row. For the month, equities will have underperformed treasuries by over 400 bp (chart).

Since the 2007 top, the Dow has been down more than 4 weeks in a row only once, in the 2Q of 2011.

2011 and 2013 are beginning to look very similar. Like 2013, 2011 also started very strong (black arrow). Its subsequent decline in 2Q11 (after green arrow) preceded a subsequent summer bounce and then the major August 2011 swoon (at red arrow).  The pattern between the two periods is similar.  In particular, note the very high RSI (top panel) that has been since been in decline for several months.

After 4 weeks down, the Dow may be due for a relief rally. On a weekly chart, RSI and the percentage of components above their 50-dma are in a configuration where a sharp rally within the next 1-2 weeks has typically followed. Also, note the black MA line which the Dow is sitting on. Uncomfortably, one of the two exceptions was 2011. Like then, a bounce in the near term could be a prelude to larger correction to follow.

Weekly Market Summary

The big picture story remains the same. The V-bounce off the June lows was likely to fail and retest the lows (post). That process is still underway for SPX.

After a two week decline, SPX was higher this week. Recall that entering the week, SPX was on its 50-dma, daily RSI (2) was at the lowest level of 2013 and NYMO was -80:  this is a clear set-up for an oversold rally.

Over the past two years, with each successive 52-week high, the same pattern has played out: a two week decline (A; red arrows), followed by a rise (B) and then further down into the correction low (C). This is a typical correction pattern. SPX should be in the B (up) portion now with the C (down) portion ahead.

Monday Was Not A Washout

There are a number of indicators that we track to determine whether sellers have capitulated and a durable bottom is in place. We look for at least a few (not all) of them to confirm a washout. When a high proportion are at an extreme, it's a Fat Pitch TM.

And by that measure, Monday was not a washout as only one reached an extreme.

NYMO: We have been tracking the McClellan oscillator closely. It is a very good indicator for a bounce long. On Monday it reached -100; that is an area from which the indices will normally advance higher for a few days, or longer. But note that many times a lower low will follow as the down momentum continues (red arrows).

Put/call: The options market has been subdued throughout the past two weeks (first chart) and especially during the last 4-day sell off. On Monday, calls outnumbered puts whereas fear is normally represented by a put/call ratio of 1.2 or higher (yellow shading; second chart).

The Big Move Down in Bonds May Be Over

The main points in this post are:

1. Individual and professional investors have already made a big move out of bonds.
2. The price of bonds responds to changes in fund managers weighting and less to the absolute weighting levels. Fund managers weightings are now at the bottom of the long term range. A further big move down would be unprecedented.
3. The recent change in treasury yields appears to be well out of proportion to both actual growth and inflation. In other words, the recent drop in bond prices seems to be an over reaction.
4. Putting this altogether, bond yields are either close to stabilizing or, potentially, reversing lower. This would be a positive not just for treasury bond holders but for other yield assets like dividend-paying stocks. 

In March, the 'Great Rotation' (out of bonds and into equities) was the dominant meme in the press. SPX was off to its best start in years and TLT was down 7% over the prior 4 months. It was the consensus view.

We suggested that was likely a crowded trade (read the post here). Over the next 6 weeks, that looked to be dead right. 10-year yields fell from 2% to 1.6%. TLT rose 6% and outperformed SPX by almost 500 bp. Large funds increased their bond weighting by 15 percentage points between March and May.

Of course, all that came to a screeching halt on May 2nd. SPX has since outperformed by 2100 bp.  In short, the bond trade rolled into a ditch, flipped over, caught fire, exploded and then fell down a 10,000 foot crevasse.

Changes in investors' position drives bond prices, and they have already made a big move out of bonds

Investors are well aware of this, and have acted to get out of bonds. Trim Tabs estimates that US bond fund and ETF outflows in August will be the 4th largest ever. In just 3 months, almost 3% of total assets have left funds. 

Individual investors' holdings of bonds in July fell to a 4 year low and will certainly be even lower now.  That money has, in fact, rotated into equities: their equity holdings rose to the highest level since September 2007. To be clear, looking at the chart, both of those trends can continue.

Professional investors are even more sanguine on yields. According to BAML, among fund managers with $700bn in AUM, all but just 3% expect long term rates to be higher in the next 12 months (blue line). In fact, they have not been this bearish on bond prices since early 2004, which turned out to be the high point in 10 year yields for the next two years (green shading). 

Weekly Market Summary

Earlier this year, bond yields were sinking, macro was disappointing to the downside and company sales and earnings were confirming disappointing growth. It looked dire, yet equities put in arguably the most impressive rally in over 15 years. It was a notable disconnect.

The tables have now turned. Rising bond yields suggest future growth and macro has been beating expectations to the upside by the widest margin in two years. Moreover, the outlook in Europe has brightened, with the Euro 350 index reaching new highs this week. Riskier tech and small caps have been leading. You would think US equities would be celebrating, yet the Dow has just had its worst two weeks of 2013.

US equities are having a banner year. The short term trend has weakened but the longer term uptrend is firmly in place (chart). And strength in the Euro Zone is a major positive (so long as it lasts) as half of SPX earnings are from outside the US.

Our view, as laid out two weeks ago (in several well-timed, otherwise known as luckily-timed, posts) is that investor exuberance has exceeded fundamentals (post) and that the V-bounce is likely to fail, resulting in a retest of the June lows (post). There does not appear to be any reason to change that stance yet.

Arguably, a correction through time is needed more than a correction through price. By percent, the fall in June this year and the falls in April-May and Oct-Nov last year are nearly the same (8-10%). But the corrections last year took twice as long (9-10 weeks) as the one this year. Time allows investors to exit equities, establish defensive positions and to become bearish. Ideally, equities correct through late September which, happily, coincides with the dominant seasonal pattern.

Emerging Markets: The Global Macro and Sentiment Trade

The case for investing in emerging markets (EEMs) right now is this: funds are at a record underweight and macro expectations are beating to the upside by the largest amount in the past two years. That is a potent combination: in addition to growing local consumption, EEMs are export-driven, especially of commodities, that would come back into fashion with improved G10 macro growth.

Moreover, EEM equity markets are highly sensitive to foreign fund flows: rebalancing in the past has led to outperformance. But, and this is key, that works both ways: when developed markets fall, EEMs do as well and more often than not, they fall harder. That, in short, is the risk/reward for EEMs.

Correlated sympathy plays on the same dynamics are steel (SLX) and copper (JJC).

EEMs are the most out of favor equity region among fund managers right now (green line). A net 19% are underweight at the moment, the lowest in 12 years. The last time EEMs were this out of favor was late 2008 and EEMs outperformed SPX through the concurrent trough. In comparison, in February, EEMs were the most favored equity market (43% overweight) and they subsequently have been the worst performing equity region of 2013.

In comparison to all asset classes and on a relative basis, EEM equities are the single most out of favor and under-owned asset.

Fund Managers' Current Asset Allocation - August

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 oversee a combined $700b in assets.

Overall, fund managers are extremely bullish on risk. In August, they further reduced their exposure to bonds (57% underweight) and increased their exposure to equities (56% overweight). Fund managers equity weighting is now in the top 5% since 2007.

Managers are now overweight the US equities by 30%, an increase of 5 percentage points in the past two months. They were 3% underweight the US in January, for comparison. Managers increased Europe to 17% overweight, the highest in 5 and 1/2 years, from just 3% in July. They decreased Japan to 19% overweight from 27% last month. Meanwhile, emerging markets are now 19% underweight, the lowest since the survey began in 2001.

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 bearish EEM, so keep it on your radar. In comparison, they were 20% underweight Japan in December and it has been the best equity market in 2013.

The US is now the largest consensus long. In the history of the survey, the current weighting is the third highest. This is consistent with the AAII asset allocation survey and fund flow data showing July to be the largest inflow into equity funds and ETFs ever.

Weekly Market Summary

SPX seems likely to be approaching a key juncture.

On Monday, both COMPQ and RUT made new closing highs. The Euro 350 also made new highs this week (chart). A majority of sectors are near their highs and key moving averages are rising (chart). It's difficult to be bearish when the trend is this strong and, seemingly, expanding outside the US.

Macro expectations are also rising. US macro is now exceeding expectations by the most in 2013; G10, by the most in nearly two years (chart). This matters, since these rising measures correlate with better EPS growth and higher PE multiples.

The rub is that the V-bounce pattern in SPX from the June low has failed every time in the past 20+ years (read today's post here). In each case, a retest of the recent low (8% lower from here) has ensued. So, while returns for 2H 2013 have a 80% probability of being net positive, the near term risk is equal or probably greater than forward returns.

These downside risks are enhanced by very bullish investor sentiment (read today's post here). Schaeffer's remind us that the last time Investors Intelligence bears were this low, SPX dropped 20% in the ensuing months. Likewise with the equity-only put-call ratio (chart).

The 2Q13 reporting season is almost over.  90% of companies have already reported and the results are mediocre. 2Q EPS growth is tracking just 2.1%, the third lowest growth rate in 4 years. Excluding banks, EPS growth is actually negative 3.1%. Revenues are tracking 1.8% growth, which is in-line with GDP and EPS (i.e., margins are flat). This is concerning, as consensus EPS growth is 7% and 11% in FY13 and F14, respectively. The market is at risk of revaluing lower when consensus shifts to meet reality. Already, 68 of 85 SPX companies (80%) have issued negative 3Q EPS guidance.

The technology sector, which has been leading the market, has had some of the worst earnings figures. 2Q EPS growth is tracking negative 8.2% and expected 3Q earnings growth has fallen to 1.6% from 5.5% on June 30. Read more here.

In the short term, the SPX pattern we have been tracking on twitter is shown here. It triggers with a move below 168 and becomes invalid with a sustained move over 170. 

How Are Investors Positioned and What Does It Imply Now and in 2014?

If you are fully-invested long and in a profitable position, you would feel even more confident if you knew a majority of investors were in cash wanting to get into the market. This is an assertion heard frequently, but is this the case at present? A look at the data and the implications below.

Individual investors ('retail') are now more long equity (65%) than they have been since September 2007 (blue line, below). Their cash balance (18%) is 6 percentage points below average. Their holding of bonds (17%) is at a 4 year low. In short, retail investors are already in the market. Can they get even more long? Of course, but the point is we are not at the beginning of the cycle. Readers of this blog know that professionally managed funds are likewise positioned long equity, short bonds (here).

Moreover, investors are continuing to pile into equities. In July, fund flows into mutual funds and ETFs reached an all-time high, surpassing the highs from the tech bubble peak in February 2000 (data from Trim Tabs).

Risk-Reward Is Again Biased to the Downside

In general, stock market odds favor the long side. Since 1980, the probability of making a positive return each year has been 76%.

When the year starts strong, like 2013, the probability of making a positive return in the second half of the year is even better. Since 1950, when SPX has been up more than 10% in the first half (1H) of the year, it has been up again in the second half (2H) 79% of the time.

SPX gained 13% in the 1H; so far in the 2H, it's up another 5%. Should investors expect more gains through year end?

The answer is yes, but expectations should be modest.

In the years with strong 1H gains referenced above, gains for the 2H have averaged 7%, 2 percentage points more than the gains so far. Looked at another way, total 2H gains have averaged about 40% of 1H gains; in 2013, that implies net gains from here through year end of less than 1%.

A strong 3Q helps. When 3Q finished up more than 5%, 2H averaged gains of 9.8%, implying another 4.8% upside for 2013. This, coincidentally, gets SPX to 1775 where JPM has its year end target, the most bullish forecast on Wall Street.

Against this upside (reward), what is the downside (risk)?

While the trend in the US indices is strong, historically, the pattern from the June low has been bearish. In the past 20+ years, the SPX has never successfully V-bounced and continued higher without a retest of the recent lows.

The first chart is SPX weekly since 2003, the second chart is from 1991-2001. Notice that after every long uptrend, SPX corrected (red shading; the width of the shading is 3 months). Every V-bounce, where SPX returned to the recent highs within 3 months eventually failed and either retested or exceeded the lows (shown with red arrows). When the correction was longer and slower (blue arrows), the ensuing uptrend was more successful.

In the current situation, SPX has already chosen the V-bounce pattern; it would be the first time since at least 1991 if it does not make a retest of the June low in the weeks ahead. This implies downside (risk) of 8%. If the retrace is a Fibonacci 62% (not common, in the examples below), then downside risk is 5%, or equal to JPM's upside target.

Net, risk-return is probably at best 1:1 and probably closer to 2:1 to the downside. Importantly, should a retest of the lows occur in the weeks ahead, recall that the odds favor a strong 2H.

Weekly Market Summary

This is not an "end of the rally" post. If it were, we would note:

• SPX has spiked up 20% YTD,  more than twice the average annual gain, which normally happens at the end of rallies. 
• More speculative small caps are leading, which is also typical at the end of rallies. 
• Global fund managers have increased their US equity weighting to the high end of the range and bond weightings are near record lows. Chart below.
• EPS is growing only 2% and margins have flattened; as a result, 12-month forward PEs are 10% above average and to the top of their post-tech bubble range. 
• Finally, the best year of the 4 year election cycle just ended and the coming year is the worst.  

Barring a second financial crisis, what's missing from the story above is deteriorating macro. The US economy is muddling through; SPX revenues per share are growing at 2%, as is rail traffic and GDP; there is little core PCE inflation.  In short, domestic growth is positive but slow.

This is fully reflected in 2Q financials: with 80% of the SPX having reported, 2Q13 EPS is tracking just 1.7% growth; excluding financials, EPS growth is minus 3.4%. This compares to FY13 and FY14 consensus growth of 7% and 10%, respectively. As margins have flattened, earnings and sales growth have converged.

The wild card is ex-US economies, especially Europe. For the first time since earlier this year, both the US and G10 CESI are now rising and positive. This matters, as CESI is correlated with higher EPS and valuations (post).  While there is a meme that only US equity markets are hitting new uptrend highs, this is inaccurate: this week, the Europe 350 index also made a new uptrend high. It is, in other words, confirming the macro story.

To be clear, no one is expecting explosive EZ growth. But the continent has been in recession and a drag on US earnings; if it can start to slowly grow, it will lift US earnings growth. Keep an open mind.

Our indicators:

The Bottom line remains largely unchanged for the 4th week in a row: technicals are mostly constructive, led by strong trend, better macro and low volatility. There are some divergences in breadth. Sentiment is frothy. Seasonality and valuation are headwinds.

Trend (positive): This week again brought new highs to all 4 US indices. A majority of sectors, with the possible exception of semi-conductors, are confirming the move up in indices. There are no divergences and the trend is up. This pattern (here) is still a big watch out, however.

Breadth (neutral): Both the equal weight version of SPX and QQQ have made new highs, as have small caps. This is positive. Strangely, NYMO has been negative while indices make new highs. This has happened each of the prior 3 years; it can persist for a while but its not a positive.

Sentiment (frothy): You would think the June swoon would have reduced margin debt levels. Instead, they increased. Put/call has also returned quickly to the low end. Global funds are now 29% overweight US equities (blue line). This is the high end of the range: since 2001, over 30% has been the peak (in mid 2008, late 2010, early 2012; chart from Short Side of Long):

Volatility (positive): VIX is below 12 and as close to its lower Bollinger as it has been since November. Recall that VIX has been below 10 in the past. Low can get lower.

Macro (positive): For the first time since earlier this year, both the US and G10 CESI are now rising and positive. Very important.

Seasonality (negative): We noted in May that a swoon in June should be bought as July is seasonally strong. August and September are the weakest two month stretch of the year. As Stock Traders Almanac notes, when July up >3.5% (like this year), an average dip of 6.9% follows. Moreover, the 4 year cycle just finished its best year (pink arrows) and the weakest year (green arrows) begins now.

Valuation (negative): Indices have been rising much faster than earnings; as a result, a revaluation of the market has already taken place. Forward PEs are at the top of the post-tech bubble range and price/sales is above.