Saturday, April 5, 2014

Weekly Market Summary

This is the market you are trading right now:

First, since March 20 (the day after the FOMC meeting), SPY has gapped up 10 out of 11 days. The index is actually down during this time but the stunning fact is that the sum of the overnight gaps account for a gain of $6.80. In comparison, the cash hours of the market account for a loss of $7.40. The overnight gaps have given sellers room to unload their shares during cash hours when liquidity is superior without tanking the market.

Second, with the SPX at a new high this week, the 500 individual stocks in the index are down an average of 7% from their 52-week highs (from Bespoke). Just 22% of the index was at a 20-day high and only 10% at a 1-year high on the day of the index's all time high.

Third, year to date, SPX is up 1.8% and NDX is negative. But treasuries are up 7%. Equity traders celebrating the new highs this week appear to be missing the simple fact they are underperforming a bond portfolio by more than 500 bp.

Taken together, these facts indicate that the indices are masking huge distribution. The headline of new highs in SPX and the Dow is covering for the poor average performance of stocks and the massive underperformance of equities relative bonds and commodities.

The illusion is real. This week, retail investors (as measured by AAII) notched their highest equity exposure since January and their third highest since 2007. At the same time, their exposure to bonds is now the second lowest since the 2009 bottom. In other words, investors are increasing their exposure to an underperforming asset class at the expense of the superior performer. Here is how SPX performed following the three prior highs in equity exposure since 2007.

Active investment managers (as measured by NAAIM) are under the same illusion. As a group, they are 91% long. More importantly, even bearish managers are relatively bullish: the spread between the most bearish and the most bullish has been this net long equities only twice before in the past 8 years: early May 2010 and early January this year. SPX fell almost 20% in the first instance and 6% the second instance.

So what's next?

Equity markets right now are bifurcated. The Dow and SPX are holding up while the NDX and RUT are breaking down.

The key question facing investors is this:
  1. Are the Dow/SPX "marking time" while NDX/RUT correct and the uptrend resumes?
  2. Or, are NDX/RUT leading and the Dow/SPX are getting ready to follow them lower?
Until Friday, on a trend basis, the argument for (1) looked stronger. SPX broke above 188 on Tuesday and then back-tested that level on Thursday.  188 became the "line in the sand" for the break out to hold. This is how SPY looked Thursday afternoon:

After a new high Friday morning, the index fell almost 2%. That constitutes a failed break out. As Brian Shannon says, from failed moves come fast moves. As a result, SPY is now back in its 6-week range. Often, having failed to break out higher, an index will test the bottom of the range (183), also the area of its 50-dma. Note the oversold RSI, but no positive divergence. Usually, a bounce and then a lower low ensues.

Importantly (and incredibly), despite the rapid fall, there was no sign of stress in the market on Friday. Put/call remained below 1; Trin was 1.1; advance/decline volume was just 2:1 negative; Vix was only in the middle of its Bollinger band; and NYMO closed at just -10. If you were looking for signs of the market capitulating, there were none to be found.

SPY daily shows the index holding above its January highs, above its 13-ema and 50-dma and clearly in an uptrend. The index isn't making any progress, but its not breaking down either. Below 183, and SPY is likely headed to the bottom of the channel (178) and/or its 200-dma (175).

In stark comparison, NDX/RUT are now downtrending. Both have three lower highs and lower lows and are back under their 50-dma after just a few days above. That's a clear sign of weakness.

Of the two, RUT looks better: its on its December pivot and if that fails, the June low trend line is just below. Look at RSI: you can imagine a positive divergence setting up on that trend line.

The cautionary note is Friday's long candle engulfed most of the week. Often, that intensity of selling leads to further lows (highlights in yellow).

NDX is weakest of the US indices. It has now broken its June low trend line and is back in its trading range from December. There's a possible RSI divergence setting up here, too. If that fails, the December low support (3450) and/or the 200-dma is the target

Biotechs are important to both NDX and RUT and account for part of their recent weakness. Biotechs have fallen nearly 20% over the past 6 weeks. That sector is now on December support with October and November support just below. A positive RSI divergence is setting up. Watch for a reversal; this will lift both NDX and RUT, at least short term.

Taking a step back, as we have continually noted this year, the larger context for the markets is not supportive of significantly higher prices.

The macro picture remains one of positive but slow growth. The non-farm payroll numbers on Friday confirmed annual employment growth of 1.6%. Forget 'weather', its been in this range for 30-months.

There has been much discussion about possible tightening in labor markets and rising wages. This, to us, has seemed unwarranted. The bond market has been expecting sub 2% inflation for some time, and those expectations have recently been falling.

The bond market, as it turns out, was right. Friday's employment figures showed zero monthly wage growth and just 2% annual growth. Wages are clearly not surging.

Bank lending to private borrowers is weak, despite low rates. In the US, loan growth is 2.5% and declining; in Europe, its minus 2.5% and declining (from BAML).

Finally, 1Q14 Eurozone PMI numbers this weak indicate GDP growth will be just 0.5%. In the US, after this week's trade deficit numbers, Macroadvisers scaled back its 1Q14 US growth estimate to just 0.9%.

All of this is material to the market in that it translates into slow revenue and profit growth.

Earnings reports start this week. Per FactSet, SPX companies expect to report 1Q14 EPS growth of negative 1.2% on revenue growth of 2.3%. The negative earnings will almost certainly be exceeded to the upside. The key take away, however, is that profits, like the economy, are growing slowly. And if the estimates are accurate, SPX margins will fall (to 9.5%).

Incidentally, the last time EPS was negative was 3Q12. During the reporting season (October-November 2012), SPX dropped 7%.

In the big picture, the current rally is entering the tail of the bell-curve, on several measures. A bell-curve measures a normal distribution of probabilities. Moving into the tail implies lower probabilities of continuing in the current direction and, therefore, the likelihood of mean reversion.

Start with the length of the current rally. SPX has now exceeded the length of both the 2002-07 and the 1982-87 bull markets. In the 130 years since 1885, only two bull markets lasted longer: the go-go 1920s (1921-1929) and the go-go 1990s (1987-2000).

The SPX rally from November 2012 has been longer above its 200-dma than every rally of the past 30 years except one (from Stock Charts).

SPX has risen 5 quarters in a row; it only risen a 6th once. The next quarter has typically lost 3-4% (from Schaeffers).

Valuations are now nearly two standard deviations from the mean. Using an average of four valuation methods, the market has only been more expensive twice in 114 years: in 1929 and at the end of the 1990s. It's in the tail of the bell-curve (from Doug Short).

Those multiples may be going higher even if equity prices decline. Recall that FactSet expects margins to fall this quarter. In the big picture, they are at an historical extreme; the tail of the bell-curve (from Jessie Livermore; a must read post here).

Finally, the latest margin debt data indicates a rise of another 3% in February to a new high. As a percent of NYSE market cap, margin debt is higher than in both 2000 and 2007. Another bell-curve tail (chart from Doug Short, amended with data from us).

So, what's the summary?

The 2013 market has conditioned everyone to keep their bearish thoughts in check. There were times in 2013 when defensive sectors and bonds led, and equities eventually rebounded to new highs.

This year seems to be different: NDX and RUT appear to be breaking down, and the large cap indices are masking wide spread weakness among individual stocks. That, taken together with the larger picture of a market in the tail of the bell-curve on multiple measures, makes a stronger case to expect NDX and RUT to now be leading SPX and the Dow lower.

Stocks normally perform well in April. It's one of the best months of the year. And perhaps it will be this year too. In a midterm election year like this one, it typically rallies through the third week of the month. The wily market from 2013 would find a way to take advantage of this; will the 2014 market?

Our weekly summary table follows: