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.
Investors are exceedingly ebullient. Fund managers allocation to equities is near their highs and their allocation to US equities has not been substantially higher since 2001. In an example of how important a correction through time is, since the May top, their allocation to equities has increased by 13 percentage points and to US equities by 5 percentage points. Allocations to risk-free treasuries are at a fresh 28-month low (post). Bottomline: when funds have been this overweight equities in the past, SPX has not moved significantly higher without moving lower first.
The longer term risk for the market is that expectations are far out of proportion to fundamentals. The 2Q reporting is essentially over: EPS growth was 2%, the lowest rate in 4 years and in line with revenue growth (i.e., flat margins). This matters, because expectations are for 7-10% growth for FY13 and FY14. Already, expected 3Q EPS growth has fallen to less than 4% from 7% on June 30th.
For the technology sector, the disconnect is much worse: 2Q growth was negative 8%, 3Q expectations have fallen to 1% growth yet FY14 expectations remain for over 10% growth.
Fundamentals have been lagging for two years. The upshot is most of the growth in SPX has been multiple expansion: SPX has increased 34% since 2011, of which 28% is from multiple expansion. So, more than 80% of the change in SPX is accounted for by multiple expansion and less than 20% by earnings growth. That tells you how bullish investors are and how urgently fundamentals need to improve.
Which brings us back to the disconnect between equities and bonds discussed at the top of the page.
Company sales and profits are growing slowly. Economists are lowering GDP forecasts (read) and the rate of growth is already the lowest outside of a recession (chart). Inflation expectations are at the low end of the range (chart). Yet, bond yields are soaring (meaning, Mr Bond sees growth and inflation in the future) and only 3% of fund managers expected lower yields in the next 12 months. They are, as mentioned, massively underweight fixed income. Something seems rotten in Denmark (Hamlet) and a realignment would greatly impact equities.
In the short term (the coming week), a bounce should be expected before price continues lower. SPX has been down 2 weeks in a row; in the past 2 years, it has only been down a third week once (May 2012). Daily RSI(2) is the lowest of 2013 (chart). NYMO is negative 80, an area from which it is normally close to a reprieve (blue lines), even on the way lower (arrows; chart below). Seasonality this week is 2:1 positive (chart). A VIX short term equity buy set up almost triggered Friday (chart). And SPX is on its 50-dma, near a large gap fill and having completed the measured move of its H&S pattern (chart).
