Weekly Market Summary

While equities have recently become volatile, the underlying fundamentals have not changed.

Companies are nearly halfway through their 3Q reporting period. Since the end of 2013, earnings have grown about 6% while sales have grown less than half that (3%). That means margins have continued to expand, by about 20bp.

That 6% growth in earnings is equal to the change in SPX year to date. So earnings multiples are no longer driving the market higher as in prior years. Instead, the market is being driven, equally, by sales growth and margin expansion.

Coming in to 2014, many believed that higher wages and interest costs would begin to erode margins. That hasn't happened. But margins do appear to be flattening. 3Q margins are tracking 20bp lower than 2Q. That's noteworthy as the margins for small cap companies already started to decline last quarter (chart).

Weekly Market Summary

After 27 months, SPX experienced its first 10% correction this week.

As we have detailed many times, this was an exceptionally long and uncorrected rise. Since its last 10% correction in mid 2012, SPX has risen an exceptional 59%.

Bulls will contend that the 2003-07 market was completely devoid of 10% corrections. This is misleading. That bull market struggled to break-even into the third quarter every year. It was a slow grind higher, completely unlike the pace of the past two years.

The big question is whether the correction is over and stocks will now rally into year end.

There were several indications that this week produced a wash out low. The most impressive of these is breadth.

SPX breadth became more washed out than at any time since the 2011 lows. By mid-week, just 40% of SPX stocks were trading above their 200-dma. Throughout the 2003-07 bull market, that level marked significant lows (lower panel). It also marked lows in 2010, 2011 and 2012 (green arrows).

Fund Managers' 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 allocated in various asset classes. These managers oversee a combined $700b in assets.

Here's a brief recap of the past several months:

In July, fund manager equity allocations reached a bullish extreme. At +61% overweight, it was the second highest since the survey began in 2001, a clear risk to near-term equity performance (post).

By August, the Euro 350 dropped 8% and SPX dropped 5%. In response, equity allocations fell and cash shot up to 5.1%, a high level associated with lows in equities (post).

In September, equities in the US hit new highs; Europe rallied, but fell short of new highs. Fund managers raised their global equity exposure and reduced their cash (post).

In the past month, equities worldwide have fallen more than 7-10%; most markets are now negative for 2014.  Bond yields are making new lows. One would expect fund managers to hold very high levels of cash, low equity exposure and much higher bond exposure.

It hasn't happened.

In October, fund manager cash has moved higher, to 4.9%, but this is less than it was in August. Instances are very low, but over 5% represents bearish sentiment. There's room for cash to rise further. 

Weekly Market Summary

SPX has gone 476 days without touching its 200-dma. Outside of 1998, this is the longest stretch since the 1950s. On Friday, after a 3% fall during the week, SPX landed right on its 200-dma.

It would be unusual if SPX dropped right through its 200-dma by more than ~2% without first bouncing higher. Unusual, but not impossible. In October 1987, after spending 10 months above its 200-dma, SPX closed right on it. Two days later, the index lost 30%.

In the past 5 years, SPX has had four similar "first touches" of its 200-dma (arrows). Each time, the index moved higher without losing more than ~2% first. The likelihood of this happening here, given the length of the rally, would seem to be very good.

Weekly Market Summary

The bottom-line is this: if the pattern of the past two years is still driving the market's playbook, then a re-test of recent highs is on the way. Enough extremes in shorter term measures of market stress have been reached in the past two weeks to mark a washout.

The key missing element is time. The down cycles have become increasingly short. This one was less than 2 weeks. Quick falls do little to reset longer term measures of investor sentiment.  The market will remain at risk of a more significant fall until investor sentiment is also washed out.

Let's focus first on the positives.

On the mid-week low, less than 30% of the SPX was trading above its 50-ema, and less than 20% was above its 20-ema. These have been washout levels in the past 3 years.

October Macro Update: Growth With Falling Inflation

In May we started a recurring monthly review of all the main economic data (prior posts are here). At the time, the consensus view was that growth in wages and employment were accelerating and that this would lead to a meaningful increase in inflation above the Fed's 2% target. So far, this has been wrong.

This post updates the story with the latest data from the past month. Highlights:

• The inflation rate continues to drop. It's well below the Fed's target of 2% yoy.
• Several measures of demand growth picked up: real retail sales growth was the highest in a year. Real GDP and PCE were revised higher to 2.6% yoy.
• New houses sold was the highest since May 2008.

Our key message has so far been that (a) growth is positive but modest, in the range of ~4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely. This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels.

With the latest data, our overall message remains largely the same. Employment is growing at less than 2%, inflation and wages are growing at less than 2% and most measures of demand are growing at roughly 2.5% (real). None of these has seen a meaningful and sustained acceleration in the past 2 years. The economy is continuing to slowly repair after a major-financial crisis. This was the expected pattern and we expect it to continue.

We'll focus on four categories: labor market, inflation, end-demand and housing.


Employment and Wages
The September non-farm payroll (248,000 new employees) was slightly above the middle of a 10-year range. (The past 12-month average of 220,000 was also in the middle of the range). This follows prints of 84,000 in December, 288,000 in June and 180,000 in August. Moving between extremes like these is nothing new: it has been a pattern during every bull market. Since 2004, NFP prints near 300,000 have been followed by ones near 100,000 (circles).

Interview with Financial Sense on Investor Asset Allocations and Equity Valuations

We were interviewed by Cris Sheridan of Financial Sense on September 24th. During the interview, we discuss investors' asset allocation, the macro environment, corporate valuations, liquidity and market technicals.

Our thanks to Cris for the opportunity to speak with him and to his editor for making these disparate thoughts seem cogent.

Listen here.