Weekly Market Summary

A short holiday update.

Trend: The trend in US indices remains strong, following through on the strength that began last week. None of the indices or any of the 9 SPX sectors closed below even their 5-dma. This will be the first warning that weakness is afoot.

Weekly Market Summary

US markets end the week back in an uptrend, led, interestingly, by SPX and the Dow, with NDX and RUT lagging. A majority of sectors regained their rising 20-dma (short term) and 50-dma (long term) trend.

SPX is back above a rising 13-ema (yellow circles). With this week's new high, it fulfills the pattern we described two weeks ago - that 8 week streaks of higher closes do not end an uptrend, a higher closing high is high odds (post).

A Breadth Warning From NYSI and NYMO

2013 is the year breadth divergences appeared to be irrelevant. There have been seven major distribution days (90% down volume) and only one major accumulation day. The summation index declined from January until May without much impact on equities. And since May, the percentage of SPX stocks trading over their 200-dma has been in decline.

Today comes a new warning from the McClellan oscillators, NYSI and NYMO. NYMO measures the momentum in breadth and NYSI sums those values daily. A string of negative NYMO readings therefore causes NYSI to go negative. For more details, read here.

Aside from a few days, NYMO has been negative since October. As a result, Summation went negative at today's close.

Since 2000, NYSI (bottom panel) has been negative 20 separate times (yellow shading). Every time it has done so, SPX has not formed a durable bottom until NYMO (middle panel) has capitulated, meaning it closes at minus 75 or lower. The lowest close in NYMO so far has been minus 53. Today, it closed at minus 18.

Fund Managers' Current Asset Allocation - December

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 as the results reflect how managers are positioned in various asset classes. These managers oversee a combined $700b in assets.

Overall, fund managers remain very bullish on risk. In September, exposure to global equities was the second highest since the survey began in 2001; it is only marginally lower now. What is particularly remarkable is how long managers have been highly overweight equities (virtually all of 2013). This is longer than any period during the 2003-07 bull market.

Weekly Market Summary

SPX has now gone 82 weeks without a 3-week losing streak. This is the second longest in the past 40 years. It's a relevant milestone, as SPX has now closed lower two weeks in a row. Will the streak end this coming week?

This week, SPY crossed above and then back below it's 13-ema (circles). This has been a pattern in 2013 (discussed last week) and it played out again this week. It came in conjunction with a second spike in the Vix Wednesday. The short term trend in SPY is down until the slope of the 13-ema reverses.

Is Wall Street Overly Bullish on 2014?

According to Business Insider, Wall Street consensus expects the SPX to rise another 10% in 2014, to 1950 (the mean as well as the median estimate). Read the article here.

Here are their YE 2014 forecasts (EPS in parentheses):

Barron's ran a similar survey this weekend. The consensus among ten strategists was a rise to SPX 1980 (+12%). See their picks here.

Is this realistic? The short answer is probably not.

Some background first.


Secular Bull Markets

In the last 115 years, there have been three 'secular' bull markets. Secular bull markets are generational in length. The most recent ran 18 years, from 1982 until the 2000 tech bubble burst. The post-war bull market ran 17 years. The major lows were in 1915, 1942 and 1974.

Many believe that 2009 was also a generational low. It fits the pattern. If this is the case, there is a long secular bull market ahead. These have gained over 500%, so there is likely a lot of gains ahead.

A Volatility Set Up For Trading SPX Into Year End

Volatility as measured by Vix spiked higher today for the first time in two months. There is a useful trade set up that is therefore worth noting.

One of the least interesting but most useful indicators in 2013 has been volatility.

Throughout 2013, Vix has been telling investors to stay long. When Vix is under 20, average monthly returns in SPX are 1.5% and returns are positive 77% of the time. In comparison, when Vix is 25-30, average monthly returns in SPX fall to just 0.2% and returns are positive only 52% of the time. The higher the Vix, the worse the returns. Details are here (post).

There were two prior periods like today when Vix was consistently below 20. Both lasted 4 years and are notable for having infrequent and shallow (5%) corrections.  Coincidentally, the prior periods were 1993-1997 and 2003-2007. Is this a 10 year cycle starting with years ending in '3'? Details are here (post).

A more frequently useful way to use Vix is to trade long equities when a volatility spike fades. Specifically, the set up is note when Vix has closed above its upper Bollinger Band and then to go long SPX after Vix has closed back below its Bollinger Band in the coming days.

We are noting this because today Vix closed above its upper Bollinger Band for the first time in almost two months.

Below are examples of this set up from 2012: the top panel is SPX, the middle panel is Vix and the bottom panel tracks closes above and below the upper Bollinger Band. The vertical green lines are signals to go long.

Every Zig Has a Zag

With SPX approaching 1800, we suggested a reaction of 4-10% was probable, allowing for an overshoot to 1820-30. This was the historical precedent at prior round numbers and it was moreover supported by other market data (post here).

Further supporting evidence is in the latest Weekly Market Summary (post here).

This post looks at the length and extent of the current rally relative to others over the past 20 years, a period which includes the late 1990's tech bubble, i.e., the strongest rally ever seen in the market.

From the November 2012 low a year ago, SPX has risen 34%. A long, strong rally, but one which is not unprecedented.

The chart below uses 1-year log-scale boxes with a 34% rise in price. In the past 20 years, there have been six other comparable rallies, four of which were in the late 1990s.

We have not included rallies off of a significant low (1994, 2003, 2009) as the start of a bull market is expected to be long and powerful.

Weekly Market Summary

Two themes continue to define the market.

First, that underestimating this bull has been the biggest mistake in 2013.

And second, that what has mattered has been trend and volatility and what has not mattered has been everything else (sentiment, valuation, breadth, seasonality).

This continues to be the case through this week, with all four indices making new highs.

We are proponents of using the 13-ema to judge trend in SPX. Two consecutive closes below is typically sufficient to make this moving average decline and provide a heads-up that a larger move to the 50-dma might be in store. The 13-ema for SPX has been rising since mid-October. This Wednesday's low nearly touched it. The trend higher remains intact for now.

Weekly Market Summary

3 of the 4 US indices made new highs this week, as did 8 of the 9 SPX sectors. Both trend and breadth are strong.

SPX closed higher for a 6th week in a row. It has closed higher on the 7th week just twice in the past 10 years (including January of this year). This kind of strength has, in the past, led to higher highs in SPX further out. The trading odds are here (via @WildcatTrader).

Coming up next for SPX is a breach of the 1800 level. In the past, centennial milestones (1400, 1500, etc) have led to anywhere from a 4% to a more than 10% reaction. We detailed this yesterday here.

Your Risk/Reward in SPX is More Than 2:1 Negative

Its very clear that US equities are in a strong uptrend. Not only are the major indices hitting new highs, but a majority of the sectors are, too (thus confirming breadth). This is not, therefore, a "this is the top" post.

SPX is approaching 1800. Over the past three years, each round number milestone (1400, 1500, etc) has been met with a negative reaction of at least 4% and at times more than 10%. On an overshoot to 1820-30, SPX has upside of 2% versus more than 4% downside, a negative profile.

Fund Managers' Current Asset Allocation - November

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 as the results reflect how managers are positioned in various asset classes. These managers oversee a combined $700b in assets.

There was very little change since October. Overall, fund managers remain very bullish on risk. In September, exposure to global equities was the second highest since the survey began in 2001; it is only marginally lower now. What is particularly remarkable is how long managers have been highly overweight equities (virtually all of 2013). This is longer than any period between 2003-07.

Time to Tank Up With Oil?

Oil has a seasonal tendency to peak in September and trough in early December. The period for positive seasonality (green shading) is now close at hand (data from Stock Trader's Almanac).

Sentiment follows the same pattern. It's now at a low where crude oil prices have tended to move higher (data from Sentimentrader).

Weekly Market Summary

The Short story:

The trend is up (chart).

Placing the Current Bull Market In Perspective

The current cyclical bull market is now second largest and third longest of the last 80 years. The current gain is twice the average for a cyclical bull market, and its length is almost 2 1/2 times the average.

The bull market of the 1990s (first on the list) is clearly in a completely different league; this is a theme throughout this post (data from Ned Davis).

As the data above shows, the rate of gain in the current bull market is among the highest ever. Since the end of 2012, the slope of ascent has become even steeper. This is similar to mid-2006 to mid-2007 (arrows).

Weekly Market Summary

There's a short story and a long story.

The short story:

Trend: All the US indices made new uptrend highs this week. A wide group of cyclicals lead domestically (chart). Ex-US indices, especially Europe, are supportive (chart).

Breadth: Breadth is confirming trend. The number of stocks trading higher on the NYSE reached a new high in October. And more of the SPX is trading above its 50-dma than at any time since May.

Seasonality: Equities are entering what is traditionally its strongest 3-month stretch of the year. And when the summer has been strong (like this year), the winter has been up an even higher percentage of the time. For further discussion, read our recent post.

Volatility: Volatility is low, a set-up for higher equity prices.

Macro: Worldwide PMI data for October was good. The Chicago PMI increased by the most in 30 years. This would seem to indicate rebound in economic growth.

In summary: Taken together, this looks like a lay-up for higher prices over the next several months. For RUT, if the pattern holds (match the colors of the arrows), support should be within the next 2% (chart).

The Best Six Months Start Now

The end of the "worst 6 months" in the stock market is upon us. Tomorrow is November 1, when seasonality turns positive.

We last wrote about seasonality in April. Our bottom-line was this: May to October is less bad than you think (post). Median returns since 1970 on SPX are 8% during winter (November to April) and 4% during summer (May to October). "You might sell in May and buy back higher in November."

This summer was exceptionally strong: since May 1, SPX is up almost 11%. This puts it in the top 17% over the past > 40 years.

Below are the SPX returns by season since 1970. Summers are red and winters are blue. The arrows show returns in the summer of over 10%.

What to expect in the month's ahead? Normally, a very good return.

Weekly Market Summary

Trend, Breadth, Volatility and Seasonality Are All Positives

10 days ago, the market's experienced a momentum kick-off. The indices, which have been traveling in 5-month channels, hit their bottom rail.  Put/call spiked to an extreme, indicating fear. This was followed by a plummet in volatility and the year's first 90% up volume day (chart). That combination of events has been a set-up for a new leg higher in the market in the past, and it appears to have been one this time as well (post).

Since then, SPX has been up 7 of the last 8 trading days.  On Friday, it closed back at the top of its channel.

How violent has this move been? Consider that at the low, SPX, NDX, RUT and 7 of 9 SPX sectors closed below their lower Bollinger band. Today, all of those closed above their upper Bollinger band for a second day in a row. That's an extreme swing.

What is particularly remarkable is the breadth of this rally. Today, the cumulative breadth of the NYSE exceeded its May high for the first time. Technicians regard this as confirmation of the uptrend (i.e., price and breadth agreement), as leadership is broad (chart). This is a positive, long-term development.

With the exception of utilities, all the SPX sectors are at or above prior highs (chart). The same is true for 3 of the 4 indices (Dow being the exception). Ex-US markets, especially Europe, are also breaking higher and confirming the US market (chart). All of this is also very positive for the long term.

So, to be clear, trend and breadth both appear strong. Add in low volatility and the start of the strongest 3-months of the stock calendar (November-January; also, 4Q up 83% of time after a strong September, here), and investors have a feel-good story.  Josh Brown summed it up well here.

Against this, we would continue to strongly caution against excessive bullish sentiment. Like the fund managers surveyed by BAML, a poll by Barron's finds bulls outnumbering bears by more than 8:1 (here).  In both surveys, fund managers are long growth/beta.

Fund Manager's Current Asset Allocation - October

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 as the results reflect how managers are positioned in various asset classes. These managers oversee a combined $700b in assets.

Overall, fund managers remain very bullish on risk (or, as BAML puts it, "steadfastly optimistic, undisturbed by events in DC"). In September, exposure to global equities was the second highest since the survey began in 2001, while exposure to fixed income was at the second lowest ever.

Weekly Market Summary

Coming into this week, SPX and the Dow were near the bottom of their long term (read: strong) channels, with a majority of sectors and ex-US indices holding up well and breadth signaling the market was oversold (post).  "Assume they (the channels) hold and these indices move higher."

By Wednesday's close, SPX, NDX, RUT and 7 of 9 SPX sectors were below their lower Bollinger. This is extreme, indicating that investors were selling indiscriminately (post). Moreover, put/call, which has been indicating complacency, jumped to a rare level of panic (first chart). And Vix spiked higher and made a double close below its upper Bollinger within a few days, a reliable bounce pattern in the past (post; second chart). Combined with the touch of the channel bottoms, these were reasons to expect the indices to change direction and move higher (post).

Thursday's action was remarkable. For the first time in 2013, breadth volume was more than 90% positive (post). In the past, this has often been a momentum kick off for the next leg higher in the market. Friday followed through.

The correction in SPX from the September top was 5%. That matches the correction in August and is shy of the 8% drop in June.

So, is that it for the correction? It might be.

Weekly Market Summary

Into the FOMC peak two weeks ago, SPX had risen 11 of the prior 12 days. Since then, it has fallen 9 of the past 12 days (post).

The selling has been concentrated in the large cap indices: SPX and the Dow. And here the good news is that all the selling has brought the SPX and the Dow to the bottom of their respective one-year and half-year channels (charts below). These long term support levels should be respected until broken. In other words, assume they hold and these indices move higher.

Moreover, SPX has just finished its 2nd down week in a row. It has not had a 3rd down week in a row since May 2012. Breadth supports at least a short term bounce (chart).

With the notable exception of financials, a majority of US cyclicals are holding up well (chart), as are ex-US markets (chart).

Macro and volatility continue to support longer term gains as well. In fact, the ratio of 1-month to 3-month volatility has spiked to a level where at least a short-term rally in SPX has typically taken place in the past (chart).

Finally, when SPX has a strong summer like this year (summers are normally weak; winters are when most market gains take place), the following 6 months are typically strong, gaining an average of nearly 10% (article).

Net, there are many reasons to expect SPX to finish 2013 strongly.

There's only one problem: nearly everyone has that view.

This week, Investors Intelligence reported the second lowest level of bears of 2013 (chart and chart). At the same time, AAII reported that individual investors increased their equity exposure to the second highest level of 2013 and reduced bond holdings to their lowest level in 4 years (post).

These data points are completely consistent with fund managers being extremely overweight equities (post), put/call being at a persistent low (chart) and short positions at record lows (article). Investors are not on the sidelines (chart).

In other words, everyone is expecting a big rally in stocks. The market is rarely so predictable.

What makes these asset allocation levels particularly noteworthy is that SPX is net flat since mid-May, four and half months ago. So investors have been getting unhedged long into a market that has gone nowhere. Who's buying? According the BAML, 'retail' investors are net buyers and institutions ('smart money') are net sellers (chart).

And when you are very bullish, as investors appear to be, what do you buy? High beta stocks, of course. Which makes it unsurprising that the RUT and NDX are outperforming by a wide margin (chart). The market is being driven by a chase for beta (post).

SPX is the best representation of US equities. The index accounts for more than 75% of total US market cap. In comparison, the RUT is just 9% (chart). The 6 largest components of the Dow are larger than the combined 2000 companies in the RUT. The weakness of large caps is not some sideshow. It's the main attraction, and the picture is one of faltering momentum (chart and post).

Assuming the debt-ceiling debate is resolved (it will be), the near term key to get momentum back into large caps is earnings growth (read a full post on this topic here). Earnings season starts this week. The consensus expects EPS (+3.2%) and sales (+2.6%) growth to pick up over 2Q, and for margins to expand. The bar is set even higher for the 4Q, with EPS growth of +10%. The next two quarters are essential for FY13 EPS to meet expectations of nearly 6% growth.

Expected to lead the growth are the financials (chart). Excluding them, EPS growth drops to a paltry +1.9%. It is noteworthy, therefore, that during 3Q, financial stocks significantly lagged the market (chart). Investors are apparently skeptical. The technical picture for financials, with its declining 50-dma, is bearish (chart).

It's also noteworthy that the consensus expects margins to expand yet, according to GS, they have already started to contract (chart). With revenue growth of just 2%, margin expansion is a must-have for EPS growth to meet expectations.

The rubber meets the road for corporate earnings starting this week.

What Does Small Cap Outperformance Tell Us About SPX?

For good reason, investors are looking at the performance of the Russell 2000 (RUT). In 3Q13, RUT outperformed SPX by a wide margin, up 9% vs 4% for the latter. It performed even better than the Dow, which was up just 1% (chart).

Some background: RUT comprises 2000 companies with an average market capitalization of $850m. For SPX, the average company is over $30bn.

These are small companies, much less followed by Wall Street analysts, in turn making them more speculative. The average beta of RUT is about 30% higher than SPX. This is key. When equities are in favor, you should expect RUT to outperform SPX. The reverse is also true when equities fall out of favor.

So is RUT outperformance meaningful to SPX? Not really.

The chart below compares SPX (top panel) to the relative performance of RUT to SPX (bottom panel). When RUT outperforms, the line in the bottom panel rises.

And what we see over the last 10 years is that sometimes SPX rises to new highs when led by RUT (green arrows) and sometimes it does so when RUT lags (red arrows). The relationship is not clean enough to be helpful in understanding SPX better.

What is, in fact, worrisome is that RUT outperformance has often been a precursor to SPX topping out (again, the green arrows). That is essentially the situation today where the level of outperformance is equal to that in mid-2011 before a 20% correction.

So, what's going on? Two points.

Weekly Market Summary

Overall, indices and sectors are trending higher. A majority of cyclicals that broke higher two weeks ago (green shading) have held those gains over the past week (chart). Likewise with most indices, including those outside the US (chart). The notable laggards are the Dow and SPX.

The story so far is this: 2013 started like a rocket, with SPX jumping ahead by 18% by mid May. This is twice its typical annual return. The conventional wisdom in May was SPX would quickly go to 1800 in 2013.  It was in the bag.

Instead, in the 4 months since then, SPX has returned a net of zero. Moreover, risk/reward has been 3:1 negative during that period of time (i.e., upside relative to drawdown).

Despite this, core sentiment remains firmly in the 1800 and higher camp. To take advantage, fund managers have increased their equity exposure by more than a 1/3 since May (post).

So have individuals: according to Lipper, flows into equity funds and ETFs was the highest in more than 10 years last week (chart).

Since downside risk is considered minimal, margin debt also increased to a new high (chart).

And, not wanting to be left behind, former bears on Wall Street have capitulated (here).

There are few better examples of investor's confidence in the upside of equities than recent put/call ratios, which have been falling even as indices dropped over the past 7 sessions (chart). That's fairly remarkable behavior.

The big picture of a market losing momentum continues to be valid (post and chart below). Breadth confirms (chart). With investor expectations ahead of market performance, there is a potential for disappointment.

Weekly Market Summary

The surprise non-taper by the FOMC on Wednesday pushed all the indices and a majority of sectors to new highs. This created a large number of extremes that we noted at the close was likely to cause near term weakness (post). Indeed, by Friday, the Dow had given up all of its FOMC gains.

But, overall, most of the sectors, US indices and ex-US indices are holding their break outs and remain above rising 20 and 50-day moving averages (chart and chart). In particular, EEM continues to outperform domestic equities over the past 3 months, a good sign (post and chart).

Treasuries, which have been trading in tandem with equities recently, diverged higher. For the week, they handily outperformed equities and since August 2, performance between treasuries and SPX is near even (chart).  Out of favor bonds (chart and chart) look like they might have put in a bottom for now (post and chart).

Looking ahead, our biggest concern is an apparent loss in momentum.

Breadth is indicating a loss of momentum. Although indices have formed higher highs between May, August and September, cumulative breadth and the percentage of companies over their 50-dma has formed lower lows (chart).

This divergence in breadth indicates waning momentum as fewer stocks participate in the market's upside. That pattern of momentum loss is easily seen in the weekly Dow (here) and SPX (below) charts (note both RSI and MACD). As a guide as to what has happened previously under similar circumstances, this pattern in the Dow (here) continues to track.

Weakening momentum will be encouraged by two other factors.

Post-FOMC, Expect Some Reversion

On twitter, we have discussed the breakout in both sectors and indices. That is the trend, and betting against the trend is frequently short-odds.

But there were several extremes that became present an hour after the FOMC announcement. The combination of these extremes (as opposed to each one individually) suggest at least some near term consolidation if not reversion.

SPX hit its upper trend line from the May and August tops (red dashed line).

NYMO was 87 at the close. This is an extreme. Prior examples over 80 shown with a green arrow.

Fund Managers' Current Asset Allocation - September

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 as the results reflect how managers are positioned in various asset classes. These managers oversee a combined $700b in assets.

Overall, fund managers are extremely bullish on risk: exposure to global equities (60% overweight) is at the second highest since the survey began in 2001. At the same time, exposure to fixed income (68% underweight) is at the second lowest ever.

The upshot is this: in the past 4 months, both All World Ex-US Index and the SPX are net flat, but fund managers have increased their equity overweight by 17 percentage points. Since 2007, equities have not moved appreciably higher without moving lower first when funds are extremely overweight equities (dashed line is the current weighting).

Weekly Market Summary

On Monday, the intermediate trend turned back up. The 13-ema regained a positive slope and SPX closed above its 50-dma after being below the prior 3 weeks. A majority of sectors and indices are similarly above their key moving averages, led, importantly, by cyclicals (chart).

As mentioned in the past several weeks, what is particularly encouraging is the positive trend is being echoed in ex-US markets. The Euro 350 made new uptrend highs, the All World Ex-US index is close to doing so and EEM is outperforming SPX (chart). In 2013, the US has led, often alone; now, other markets are pushing higher as well.

Add to this both low volatility and macro beating expectations by the most in almost two years (chart), and investors have a feel-good story.

And there is no doubt investors feel good. All three put/call ratios hit extreme bullish readings on Monday and Tuesday, a rarity (chart). As Chris Prybal points out, put/call is now back at the same May/August level where SPX has subsequently fallen (chart). Similarly, AAII bullish sentiment is back near prior highs where, absent a recent long sell off, SPX has made little net progress (chart). The bull market is even on the cover of this week's Time magazine.

The market appears to be, in short, stuck in the late-stage rally dilemma: investors are very bullish, so each correction is short and shallow. And the lack of a more meaningful correction, one that shakes out longs and brings in fresh capital to fuel the next leg higher, leads to declining momentum.

The waning momentum is most evident on longer time frames. On the SPX weekly, the RSI (5) is making lower highs and lower lows without ever getting 'oversold' where the market resets and begins a successful leg higher (noted by green arrows). The shallow corrections (red arrows) have eventually failed each time.

In fact, 2013 is so far the first year since 1995 where the weekly RSI (5) has not become 'oversold' even once. Aside from that being 18 years ago, what is equally unusual is that in all the prior cases, the previous year has been a 'washout', either falling hard (like 1987) or trending sideways (chart). That type of action resets markets and establishes the base for the next sustained move higher. In comparison, the strength this year follows on the 13% gain made in 2012.

Waning momentum is also seen on the daily SPX chart. There have been 4 prior times since December where SPX has run higher at least 7 days in a row (like this week). In the following days/weeks, SPX has made minimal net progress (chart). Each of the prior times was a stair-step higher; this time, the rally overlaps with the one in July. In other words, a lot of energy was expended getting back to where SPX was two months ago. That is the very definition of waning momentum.

Finally, the loss of momentum is seen in breadth. Carl Futia shows that with indices challenging and/or exceeding prior highs, both cumulative advance/decline (chart) and net new highs (chart) are lagging. This implies that the rally is narrowing. Note that these divergences can persist for a time.

Nevertheless, the trend, as noted, is bullish, and with 2013 being such a strong year, underestimating this market has been an error.

But be aware that this rally to be getting tired. Two weeks ago we suggested that 2011 and 2013 are beginning to look very similar (post). If this is the case, then large cap stocks will form a slightly lower high in the weeks ahead with yet another lower weekly RSI (red arrow). The 2011 red arrow came during that summer's debt ceiling debate; ironically, we are now heading into another debt ceiling debate ahead of the October 15 deadline.

Weekly Market Summary

After falling 4 weeks in a row, DJIA and the other indices bounced. Recall that DJIA had been down a 5th week in a row only once (2Q11) in the past 6 years. So, a bounce was due, but it was fairly weak: none of the indices exceeded the prior week's high, instead forming inside candles.

The bright spot in the global equity landscape is ex-US. Earlier this year, Europe began trending higher and creating new highs. As a group, ex-US markets are finally trading above rising 50-dma (chart).

The laggard emerging markets are now outperforming the US over the past 10 weeks (chart). The set up for EEM outperformance was discussed here;  to this we can add that their valuation relative to book value is highly compelling (chart). Two sympathy plays, the Aussie dollar (chart) and steel (chart), are confirming.

In the US, treasuries, which had outperformed equities by 500bp in August, gave up all those gains this week. Over the past 5 weeks, they are now back to equal performance (chart). Of note, investor positioning on treasuries could not be more lopsided (chart).

The above, on balance, is of course positive for equities on a longer timeframe. Over the next few weeks the key question is whether last week's rise was a B (up) wave in an ABC correction that lasts through September, or the start of a YE rally?

For the broader market, we have previously spelled out what to look for at a washout low (post). Many of these conditions have not yet triggered. Despite weakness in US equities over the past month, allocations to equities (chart and chart) and investors' outlook (chart and chart) have not changed by much. Breadth (chart) and the SPX 13-ema (chart) are also in a short-term bearish configuration. All of this suggests a final C (down) wave is likely to come, but the end of the correction is probably close.

September 2013: What Will Drive Equities Higher In The Next 12-Months?

This rally, which started in 2009, has now run 1640 days, which is well over double the average 'cyclical bull market' of the last 80 years (article). It is, in fact, the third longest cyclical bull market of the post-depression period. The percentage gain (140%) is also nearly twice the average and the third highest.

It is, in other words, the right time to ask what, if anything, will drive the indices higher before they instead head lower.

(Note: 'Cyclical' bull markets are distinct from 'secular' bull markets. A secular bull market (1982-2000) is generational and comprised of several cyclical bull and bear markets, each lasting two years on average (as above). Read further here or here. This post is only focused on the cyclical trend).

There have been two distinct stages to this bull market.

Stage One ran from 2009 to late 2011 and was driven primarily by fundamentals: strong sales growth and strong earnings growth (EPS doubled; sold blue line below). In Stage One, fundamentals outpaced the appreciation in the indices.

The second stage has run from late 2011 to the present. Fundamentals have slightly improved but Stage Two was overwhelming about the indices becoming revalued upwards. Since the end of 2011, less than 20% of the gains in the SPX can be accounted for by EPS growth; the remaining 80% has been multiple expansion. The chart below shows the rise in the trailing 12-month (TTM) PE; it has increased by one-third in Stage Two.

If fundamentals drove Stage One and valuation drove Stage Two, what will drive the next leg higher?

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).