Saturday, May 3, 2014

Weekly Market Summary

The biggest catalyst coming into this week was seasonality. Normally, the end of April and beginning of May is strong. There were few other extremes, except the equity put/call ratio which had spiked enough on Friday to precipitate a bounce (here).

In the event, SPX and DJIA moved up about 1%, but in most ways the bounce was weak. 80% of the gain in SPY this week came from overnight gaps higher on Monday and Tuesday. Trading during cash hours added little, indicating poor investor conviction.

More to importantly, breadth was terrible. DJIA made a new all-time closing high but here's how its 30 constituents performed: one made a new all-time high, two made a new 1-year high, only four made a new 2-month high and just 8 were at even a new one-week high.

The other indices are similar. 75% of the Nasdaq is below its 50-dma. Only 42% of the SPX is above its 50-dma even though the index is less than 1% from its all time highs. This breadth divergence is similar to July 2011 and April 2012.

This deterioration in breadth is happening when seasonality for equities typically weakens. The period from May to October is not outright bearish. Equities gain, on average, during this period. But the gains tend to be small and the next 6 months are most notable for their interim drawdowns. Large, negative months are twice as likely during May to October (yellow) as they are from November to April (post).

This means, in short, that risk/reward is skewed to the downside. In the past 10 years, there has been a sizable drop in equities during the May to July period every year except one. The sole exception (orange) came after SPX had already dropped close to 8% coming into May. When May starts at a high, like this year, there has been a drop every year.

The period of weak seasonality starts this week. There is no tailwind from the calendar until the end of May (chart from Sentimentrader).

There is also no tailwind from investor sentiment. Investors Intelligence and NAAIM bulls increased this week, despite the drop in equities the prior week.

Barron's also released its semi-annual poll of "Big Money" fund managers. As Sentimentrader points, the correlation between this group's bullish forecast and reality is 0.08. Bulls now outnumber bears by  more than 6 times. For comparison, at the start of the current advance in October 2012, that ratio was under 2 times.  They are, in short, very bullish and typically a contrarian indicator (chart from Barron's).

There is also unlikely to be a tailwind from earnings. The trend in sales over the past 3 years has been about 2% growth per annum. As we have said perviously, that is likely to be increasingly reflected in earnings. With 74% of SPX having now reported, 1Q earnings are in fact growing at just 1.5% yoy (chart from FactSet).

Given that it is at an all-time high, the financials for DJIA are frankly shocking. According to FactSet,  EPS growth has been negative 3 out of the past 4 quarters and revenue growth has been less than 1% for 7 quarters in a row.

With equities near highs yet the weakness in growth, one would expect valuations to be stretched. They are. The average price/sales ratio for SPX is now approaching that from the 2000 bubble; it is already well above the levels from 2007 (chart from Hussman Funds). A further revaluation higher is unlikely to be a tailwind for equity prices.

Finally, consider the performance of treasuries this year. In the first 4 months of the year, a bond portfolio has outperformed equities by over 800bp. The only equity sector comparable to bonds has been yield producing utilities. Growth stocks have been crushed.

This outperformance has come as the Fed has vocalized its intention of reducing its stimulus program. Yields have fallen now as they did each of the prior times QE was suspended. Why? Yields reflect growth expectations: less stimulus implies lower growth and therefore lower yields. No one should have been surprised by this, yet investors of all stripes have been massively underweight income (chart from Bespoke).

Treasuries are now entering the period of the year where they typically are strongest, especially during mid-term election years (chart from S&P Capital IQ).

If there is a stalking horse for the current market, it might well be 1996. Like 2014, the 1996 market followed a year of exceptional gains without any notable weakness. That advance then transitioned to a sideways choppy market just like the one we are seeing currently. Investors then, like now, were expecting more gains. Instead, the index dropped 10% in the summer, washing out bullish sentiment enough to set up a year end rally. A similar outcome seems likely now (a post describing 1996 versus 2014 is here).

The Week Ahead
Despite the many reasons for SPY to weaken in the next few months, the reality is the index is still near the top of its range. It has tried and failed to move much beyond 188, in spite of numerous attempts over the past 2 months. Below 187, this latest attempt will also become a failure: that level is both support as well as the 13-ema. Above 187, the index should be considered bullish biased. RSI has not yet become oversold (below 30), but it is moving in that direction. In a sideways and choppy market, the best long set ups have been when RSI is oversold and preferably showing a positive divergence. Not yet.

RUT is still the weakest index, making lower lows and lower highs. NDX is next weakest; it is stuck below key resistance at 3620 (also its 50-dma, which is starting to decline). If it can move above this level, there is room to run to 3675. Otherwise, the trend is lower.

30 year treasuries are now trading near 1 year highs. Futures are now at a formerly strong support/resistance level from 2011-2013. The bid has been strong, investors have been excessively bearish and seasonality is a tailwind. Still, the conventional technical wisdom would be that price consolidate its gains (pause or retrace) before moving higher.

Looking specifically at TLT, it closed above its upper Bollinger Band (yellow shading) on Friday. At least 1-2 days (often more) of weakness normally follows.

Our weekly summary table follows: