It's hard to argue that the price action of US equities is not bullish. SPX and DJIA ended the week at new highs. NDX stayed near the new highs it made last week, apparently digesting its gains. NDX was flat for the week while SPX and DJIA added another 1%.
This is mostly reflected at the sector level as well. Financials, technology, industrials and transports are cyclical leaders all making new highs this week.
But what is curious is that the market is being led more by defensives. Staples, utilities and healthcare are also at new highs. Since the September 19 top, SPX has added 1%, but defensives have handily outperformed. Utilities is the sector star by a mile.
What's more, treasuries have outperformed SPX by another 400bp. TLT is up over 5% since the September top in equities. Overall, this is a market led less by growth prospects than by yield seeking. That has been the winning trade all of 2014.
Slowing growth expectations are also reflected in earnings guidance. 89% of the SPX has reported their 3Q sales and EPS. For 4Q14, sales growth is expected to fall by nearly half, to 2.2% yoy. Expected earnings growth of 9.6% in September fell to 4.5% this week. The culprits are a booming dollar and plummeting oil prices.
Slowing growth is not deterring retail investors. They have not tiptoed back into equities, they have stampeded. In the past two weeks, inflows into equity ETF and mutual funds totaled $24.2b. There was $15.4b added in the past week alone.
What makes this stunning is only $1.4b left equity funds between the September top and the October bottom. That's a tiny amount. In comparison, during the mid-2012 correction, $20.6b left equity funds. Net, since the September peak, retail investors have added $7.3b in new cash to their equity accounts.
The ebb and flow of money from equity funds is a key driver of higher prices. As a general rule, you like to see that retail investor money return to the market slowly. That is frequently a recipe for a longer run higher in the indices.
In mid-2012, for example, it took nearly 6 months for retail equity fund assets to return to their prior levels. In that time, SPX added 4% to its prior high (marked with a "1" below). It took 7 months for retail equity fund assets to return to the their prior level after the November 2012 swoon; SPX added 12% to its prior high in that time (marked with a "2" below.
Using Rydex as a benchmark, retail equity fund assets are now at a new high 9 year high. If equities climb a wall of worry, that wall is pretty short right now (more on the latest fund flows here).
Our guess is that retail investors have read any number of recent articles about how equities outperform during the winter, especially in the third year of the Presidential Cycle that starts after the mid-term elections. On average, these years see equities rally an astounding 22%. It's impressive.
There are a few problems with this set up, however. In the chart above, we have marked how SPX has actually performed (in red) relative to the expected pattern. Instead of an expected 7% gain in Year 1, SPX actually gained 30%. Instead of declining in the first three quarters of Year 2, SPX gained another 7%. It doesn't match the historical pattern at all.
And this gets at the reason why Year 3 is typically bullish: because the years leading into it are not. Since 1930, the period leading into Year 3 has been marked by a recession, a bear market and/or a substantial correction in 86% of instances. That's clearly not the case as we head into 2015. Even the 3 exceptions are very different from today (read more about this pattern here).
That doesn't imply that equities are set up to crash, only that investors seem to have front run a set up that is unlikely to unfold the way they expect. In other words, it's more than priced in.
The technical pattern coming into this week suggested that equities were set up for choppy trading, making the risk/reward of entering new longs uninteresting (read the post here). That hasn't changed.
Let's review. First, after 12 "higher lows" in a row, SPX has most often struggled in the weeks ahead; if SPX continued to move higher, it gave those gains back (chart below shows the last 3 times this set up occurred). The same is true if you look at the rate of change relative to prior periods: many times, the market did not move substantially higher over the next month or longer.
Finally, NYMO reached two extremes last week, a pattern that has reliably preceded at least a partial retrace, even if the markets moved higher first.
We can add another study that reaches a similar conclusion. This week, the percentage of AAII investors that are bearish was 15%, a 9-year low. In similar circumstances, SPX returns were below average going forward. There were exceptions (shown in green), but mostly SPX chopped sideways over the next several weeks; any gains were given back.
That large caps moved higher this week while NDX and RUT stalled was not a surprise. The seasonal pattern around elections is typically bullish. The middle of November is much less so. Markets now enter the seasonal pattern highlighted in yellow (below). A low later this month is typically a set up into a year end rally (chart from Stock Almanac).
Moreover, according to Chad Gassaway, the week after NFP has been consistently lower in 2014. The main exception was in February: recall, that week started from the 6% drop in SPX in late January. A 4% drop from late July also ended the first week in August. In contrast, Friday's close comes at a new high.
Since October 16, SPY is up $17. Remarkably, 60% of this gain has come from net overnight moves higher. If this sounds familiar, it is because we noted the same pattern at the end of March, the end of July and in early September. Each time, SPY traded lower in the weeks ahead. The short term SPY pattern now includes six substantial, unfilled gaps (yellow).
SPY has now traded above its rising 5-dma for 16 days in a row. We have discussed these streaks before, most recently in September and June. This type of strength usually does not mark an uptrend high; the momentum normally carries the market higher. A typical pattern is for SPY to trade down to its 13-ema after the streak ends (arrow); from there, it trades back to the prior high and often higher. On weakness, we will be looking for this trade set up.
Our weekly summary table follows.
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