Weekly Market Summary

Last week ended with extremes in equities, treasuries and volatility. That combination, together with positives in seasonality, were the primary catalysts for a positive week in the markets (post). But the gains this week were well beyond anyone's expectations. From their lows, SPX, DJIA and NDX all rose 5%. In Europe, DAX and FTSE each rose 6%.

RUT, which had been the weakest index in the US, closed at its highest level since early July.  It is less than 1% from making a new ATH. The glass half-full view is that 2014 was a year of consolidation. It remains rangebound until it clears the March/July tops.

Separating Facts From Popular (But False) Narratives

Investors are confronted on a daily basis with an array of confusing and seemingly contradictory information. Is the economy expanding or shockingly weak? Are corporate profits improving or just the result of tricky financial engineering? Are investors buying equities or is it all just driven by the Fed and other central banks?

The picture is much less confusing if you take a step back to look at the bigger picture. Below is some suggested reading to help separate the facts from the popular but often false narratives.

The economy is expanding at a slow but fairly steady rate. Demand is growing and so is employment. The biggest weakness lies in price: inflation has been falling. More here.

There's More To Share Outperformance Than Stock Buybacks

Stock buybacks have been grabbing a lot of headlines. Goldman estimates that buybacks in the S&P will amount to $600b in 2014, a 26% rise over 2013. And this comes on top of a 20% rise the year before.

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

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal.

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

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).

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).

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).

October: equities worldwide fell more than 7-10%; most markets were, at least briefly, negative for 2014.  Bond yields made new lows. Fund managers raised their cash levels back to 4.9%. Equity allocations dropped to their lowest levels in 2 years (post).

November: new uptrend highs in the US, Japan and Germany; cash levels fell and equity allocations rose to near their prior highs.

Since then, equities have again fallen. So it's not a surprise to see that in December, cash is now up at 5% again. This is a strong positive. But, strangely, equity allocations are also up to a 5 month high. To say that there are mixed signals is an understatement.

Let's review the highlights from December.

Fund managers increased their cash levels to 5%. Instances are very low, but over 5% represents bearish sentiment: this is where bottoms in equities have formed in the past.  The last three times cash was over 5% was in June 2012, May 2014 and August 2014. Each time, SPX rose in the month ahead.

First Major Accumulation Day in 14 Months

The markets hit a large number of extremes at the end of last week (post). More were hit Tuesday (post). These, together with positive statements from the Fed today, created a major accumulation day (MAD). These are days when up volume on the NYSE is at least 9 times larger than down volume.

That is telling you that investors overwhelmingly see equities as attractive or oversold at current prices. It's a bullish sign and normally (but not always) initiates a move higher in price.

As an aside, 'tick' on the NYSE was also strongly positive today. We look especially for a cluster of ticks over 1000 after a strong period of selling. This means that many stocks are moving up on the ask, not the bid. The highest tick today was 1350, one of the 5 highest of 2014. Overall, the profile of tick is consistent with a MAD.

Today's MAD was 17:1. It was the first MAD since the October 2013 low in SPX. In the past two years, the only other MAD was January 2, 2013. Both of these initiated long moves higher in SPX.

Weekly Market Summary

SPX and DJIA both closed at new highs a week ago; NDX did so the week before. This week, they each lost 3-4%. In the process, all their gains over the past 5 weeks, since the end of October, were eviscerated.

It might seem ironic that equities would fall so hard. After all, a week ago, one of the best employment reports in four years was released.

You can find any number of reasons for the plunge. The week after NFP is often weak. Most of the indices had hit long term trend line tops. SPX was near its 2100 "round number" resistance which in the past has been followed by a 3% or more fall. Measures of "dumb money", like equity inflows, had hit one year highs; when "dumb money" is happy to be long equities, the run is usually close to an end. These reasons, and others, were detailed a week ago here.

The question now is what lies immediately ahead. We think risk/reward on a one month basis is now positive. Let's review.

First, recall that last Friday SPX had completed a streak of 7 weekly closes higher. We looked at all 10 times that had occurred since 1980. All 10 made a higher closing high in the weeks ahead. That should be intuitive; 7 weeks higher is a sign of strong positive momentum that will not suddenly end. The trend needs to weaken before reversing. This week might be the beginning of a bigger weakening process, but it seems unlikely that last week's high marked a long term top.

How Are Investors Positioned Heading Into 2015

The latest Federal Reserve flow of funds data provides an up to date view of households' current asset allocation. Let's review.

Household's largest holding is in equities; these comprise about 31% of their total financial assets. It troughed at 18% in early 2009. Current levels are above the recent highs of 29% in mid-2007. In 2000, it was an all-time high of 36%.

S&P 500 Company Sales Are Accelerating And Margins Are Expanding

S&P 500 company results for 3Q were really very good.  Let's review and discuss what this means heading into 2015.

Sales grew 3.9% on a trailing 12-month (TTM) basis. That is as good as analysts had expected. What is impressive is that sales growth is accelerating: a year ago, growth was 120 bp lower (2.7%; data in the next three charts is from FactSet).

Weekly Market Summary

Coming into this week, SPY had been above its 5-dma for 30 days in a row. This was a new record, unlike any streak the index has ever seen. We reviewed prior examples of these streaks earlier; our conclusion was that the streak rarely marked the top in the market, meaning there were higher highs immediately ahead after the streak ended. But the index also struggled in the following weeks, often trading lower (the full post is here).

The set up we had been looking for after the streak ended was the first touch of SPY's 13-ema. That has been a reliable buy point which we have highlighted many times in the past. That occurred on Monday, with SPY at 205.5. By Wednesday, SPY had already gained $2.50.

That may not seem like much of a gain, but consider the context. In the past 4 weeks (since November 10), SPY has gained $4, but more than $2 of that gain occurred overnight on November 21 following announcements from both the PBOC and ECB to provide greater stimulus. Without that one gap, SPY is up less 1% in the past month.

Overall, the trend remains higher for both the main US indices and well as for a majority of the individual sectors. All of the US indices except RUT made new highs in the past week; all of the sectors except energy have made new uptrend highs in the past two weeks.

December Macro Update: Employment Is A Notable Bright Spot

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 soon 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:

• A bright spot is employment: NFP has been above 200,000/month since February, an unusually long period. Moreover, the 3Q14 employment cost index was the highest since the recession. 
• However, the inflation rate continues to decelerate. It's well below the Fed's target of 2% yoy.  
• Several measures of consumption continue to show demand growth of 2-2.5% yoy (real).  A sustained improvement in growth remains elusive.

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 ~2%, inflation and wages are growing at ~2% and most measures of demand are growing at ~2.5% (real). None of these has seen a meaningful and sustained acceleration in the past 3 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 November non-farm payroll (321,000 new employees) was the highest since January 2012. In the past two years, NFP has only been above 300,000 once before, in April of this year. It was a strong report, especially since NFP has been above 200,000 every month for 10 months in a row.

Note, however, that the monthly prints are volatile. Since 2004, NFP prints near 300,000 have been followed by ones near or under 200,000 (circles). The November 2013 print of 274,000 was followed by 84,000 in December. Moving between extremes like these is nothing new: it has been a pattern during every bull market. The past 12-month average of 228,000 was in the middle of the last 10 year's range.

The Math Behind Oil Prices

The fall in oil prices is gathering much attention. Since mid June, light crude oil (WTIC) has fallen by about 40%. Current prices are the lowest since September 2009, more than 4 years ago.

You would guess that this would be bullish for equities. After all, a lower gas bill leaves consumers with extra cash for other purchases. So, lower oil should mean a higher SPX.

But that doesn't look like its been the case in the past. Since 2000, SPX (blue) and WTIC (black) have moved more or less in the same direction. SPX has risen when oil prices have risen, and fallen when oil prices have fallen.

Low Odds of a Big Fall in December

Bond yields are falling, as are commodity prices. Both NDX and RUT are starting December down more than 1%. Is a December swoon set to trigger?

Based purely on seasonal tendencies, the odds of a steep fall in equities through the end of the year are low.

According to the Stock Traders Almanac, December is the single best month for SPX (since 1950) and RUT and the second best month for NDX (post). Whether you look at the last 20, 50 or 100 years, December has averaged gains for SPX (chart from Bespoke).

When 'Buy and Hold' Works, And When It Doesn't

Imagine if you had invested in the S&P 500 in 1984 and held through the tech bubble and crash and then through the financial crisis and its recovery. How would you have done over those 30 years? As it turns out, very well. On a real basis (meaning, inflation-adjusted), your holdings would have appreciated by over 400%.  A $100,000 investment in 1984 would now be worth more than $500,000.

Now, imagine that you had made that same investment only 30 years earlier, in 1954. You probably imagine that you did even better. The economy was booming in the post-war/baby-booming 1950s and 1960s and was well into a new bull market by 1984. As it turns out, you barely broke even. Your $100,000 investment was worth about $120,000 a full 30 years later.

The chart below looks at the appreciation in the S&P over a rolling 30 year basis since 1900. The line at 1984 shows the appreciation of an investment made 30 years earlier, in 1954. The end of the line to the far right, at 2014, shows the appreciation if you had bought 30 years earlier, in 1984.

Are Low Rates Responsible For High Valuations

Interest rates are low, so stock valuations should be high.  After all, a lower discount rate means that company cash flows are worth more; hence, a higher stock price. And the higher yield offered by equities makes them more attractive than low yielding treasuries, another reason to pay up for stocks.

This is a very common view.  And its bolstered by the fact than interest rates have been falling for 30 years while stock valuations have mostly gone higher. These two seem to be inversely correlated. There must be a cause and effect reason behind it.

So, is this view correct? The short answer is no.

The chart below looks at valuations versus 10 year yields. Current yields (2.3%) have been associated with valuations over 20x and under 10x. Interest rates were higher in the 1990s and so were valuations (orange dots). Valuations have been under 10x when interest rates have been over 10% and under 3%.  There is no discernible correlation between rates and valuations at all (chart by Doug Short).

What Happens When SPY Trades Above Its Weekly Bollinger Band

Today, the PBOC and the ECB both promised to provide greater liquidity to combat disinflation. US markets have gapped nearly 1% higher overnight as a result.

Coming after 5 weeks of gains, this gap will push SPY above its weekly Bollinger Band (20,2). Above a Bollinger Band means that price is more than 2 standard deviations away from the mean. At least in theory, 95% of trading should occur within a Bollinger Band. Trading outside of the weekly band is usually significant.

Let's review recent instances. In the charts below, the arrow is a weekly close over the weekly Bollinger Band.

Since mid-2013, markets have been down the next week 5 of 6 times. In the one exception, markets gave back all subsequent gains and more in the next month.

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 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 October, equities worldwide fell more than 7-10%; most markets were, at least briefly, negative for 2014.  Bond yields made new lows. Fund managers raised their cash levels back to 4.9%. Equity allocations were dropped to their lowest levels in 2 years. On further weakness, a washout low would be set up (post).

Now, the strong recovery in equity prices (to new bull market highs in the US and Japan) has pushed cash levels down a bit and equity allocations up to near their prior highs. That's especially true for US and Japan equity exposure.

Let's review the highlights from November.

Fund managers have reduced their cash levels to 4.7%. This is still relatively high on a historical basis but note that cash levels haven't been below 4.5% in the past year. We consider current levels to be neutral. Instances are very low, but over 5% represents bearish sentiment: this is where bottoms in equities have formed in the past.  

What Happens To Open Gaps in SPY

From its mid-October low, SPY has left six large open gaps. These total to nearly $6. Three gaps are more than $1 each. In the charts below, open gaps are in blue; closed gaps are in yellow.

Weekly Market Summary

SPX, DJIA and RUT ended the week nearly unchanged from last week. NDX, which was unchanged last week, gained 1.5%.

It's hard to say trend is not bullish: SPX, DJIA and NDX all made new highs intra-week; RUT briefly traded above its early September high before closing lower.

Incredibly, SPY closed between 204.0 and 204.2 every day this week. Moreover, during the past 11 days, the open/close range in SPY has been just 0.13%. There has been limited movement for 2 weeks in a row.

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 seems to be validated by this week's trading. The outlook ahead hasn't changed.

By Friday, SPX had closed above its 5-dma 21 days in a row. The only other time it has done so was in 1996. That turned out to be the exact high over the next 3 months.

Zero Hedge Might Be The Smartest Financial Blog Around

We've been blocked by Zero Hedge for 4 years. Anyone who invests knows that equity markets have a far higher probability of rising over time than they do of declining. Pointing out that basic fact to the good folks at Zero Hedge is not appreciated.

But Zero Hedge might be the smartest financial blog around. Why?

Because anyone who writes in finance knows that bearish articles are the most popular. By far. In our experience, a bearish article attracts at least 5 times as many readers as a bullish article. People like to read about The End of Days. No one wants to hear that things are right in the world, even if that's more likely.

Which makes Zero Hedge a brilliant business concept. Write only bearish articles that collect the highest number of hits. Sell advertising. Collect revenues.

If writing in finance is viewed as purely a business endeavor, their model makes the most economic sense. Well done.

A Possible Set Up For Ex-US Markets To Outperform

While the US economy continues to repair, albeit slowly, the situation in the rest of the world looks more dire. As a result, the performance of SPX relative to ex-US stock markets has gone parabolic over the last two months.

November Macro Update: Growth Is Still Missing

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 soon 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. PCE is now less than 1.5%. 
• Several measures of consumption continue to show demand growth of 2-2.5% yoy (real). A sustained improvement in growth remains elusive.
• A bright spot is employment: the 3Q14 employment cost index was the highest since the recession. 

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 ~2%, inflation and wages are growing at ~2% and most measures of demand are growing at ~2.5% (real). None of these has seen a meaningful and sustained acceleration in the past 2-1/2 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 October non-farm payroll (214,000 new employees) was in 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 and 288,000 in June. 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).

What Happens After SPX Streaks Above its 5-dma For 16 days?

SPX is currently adding to a 16 day streak of closes over its 5-dma. Since 1996, this has happened just 6 other times. It's a small sample but let's take a look at what happened next.

Most recently, SPX had similar streaks in July 2013 and August 2014. These may be the most relevant examples as both followed short falls in SPX and were part of a "-v-shaped" bounce.

The End of QE 3 Does Not Spell The End of The Bull Market

The Federal Reserve's third "quantitative easing" program officially ended last week. Many traders hold the view that equity markets have become addicted to central bank stimulus and that the end of QE 3 will therefore result in a significant fall in equities, just as the end of QE1 (2010) and QE2 (2011) corresponded with drops of 17-20% (chart from Nautilus).

Weekly Market Summary

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 Fund Flows Tell Us About Current Investor Psychology

It is true that "disbelief" is an important factor in driving equity prices higher. That is a large reason why powerful Year 3 Presidential rallies have followed recessions, bear markets and/or corrections larger than 20%; these events have had the effect of moving investors out of equities and into the relative safety of fixed income and cash (post).

The question now is whether the recent 10% correction in equities created enough disbelief among investors that they moved out of equities. If they did, a strong and sustainable rally lies ahead.

Lipper tracks fund flows into and out of both mutual funds and ETFs. The last 10% correction in SPX in mid-2012 caused a $20.6b equity outflow from the April top to the June low (left side of the chart below). Fund flows were negative for 8 of those 9 weeks. No doubt, this was significant in setting up the long rally that followed (chart from SentimenTrader).

Year 3 of The Presidential Cycle Is Unlikely To Go The Way Everyone Expects

If you even passively follow equity markets, chances are high you have already read a number of articles about "Year 3 of the Presidential Cycle". That period is starting right now, and it's incredibly bullish. In the chart below, we are entering the steep ascent where the SPX has risen 22% in a year on average (since 1950).

Weekly Market Summary

After dropping to a 6 month low in mid-October, SPX has since risen more than 10% in two weeks. The bounce has been at a torrid pace.

We had been expecting a more complex bottom to form at the low. Why? The market had risen 60% since it's last 10% correction in mid-2012.  A more typical basing at the low, to reset sentiment and breadth, seemed warranted before resuming the uptrend. This now appears to have been wrong.

Instead, SPX, DJIA and NDX all rose to new bull market highs this week. SPX has now completed its 9th "v-shaped bounce" since 2013. According to Dana Lyons, "v-shaped bounces" occurred once every 1.6 years from 1950 to 2012; since then, they have occurred every 2 months (post). To us, that reflects an unflinchingly bullish and aggressive investor psychology. The data supports that view.

This market is well-known for doing the unprecedented. According to SentimentTrader, SPX traded more than 0.5% above its 5-dma for 10 days in a row in the past two weeks. In the prior 75 years, this has only happened twice before, both at bear market lows (1982 and 2002). In other words, a rare rip higher, that has only happened after multi-year bear markets, just occurred after a mild, four week drop. It's incredible and completely unexpected.

Perhaps the most distinguishing characteristic of the current rally is this: SPX has made a series of 12 daily "higher lows" in a row. According to Paststat, there have been only 9 other instances in the past 20 years where SPX has made more than 10 "higher lows" in a row (post). This raises the question of what typically happens next.

We normally think of strength like this as initiating a broader move higher. But that was the case in just 2 of these 9 instances: December 2003 and July 2009. Both of these came within a few months of a new bull market, and in both cases, SPX continued higher. December 2003 is shown below (left side of chart).

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.

RUT Has Reached An Important Juncture

It's an overused phrase, but this is an important juncture in the market.

Weakness in the small cap index, RUT, has reached the point where just 23% of the index's components are above their 50-dma. In the past 2 years, this has been the buy point for every rally; the only time this measure of breadth has been lower was November 14-15, 2012, right before a 60% rally. Before that, it was lower on June 1, 2012, right before a 20% rally (chart from Sentimentrader).

The Set Up For A 4th Quarter Rally Is Missing Something

The end of the year is known for being seasonally strong. Even October, renowned as the month for exceptional drops, has recently been one of the best months of the year. Over the past 20 years, the October - December stretch has been the strongest period of the year (chart from Bespoke).

That is especially true during mid-term election years. These years usually meander until the 4th quarter, and then rally. Crucially, that continues into the third presidential year when stock returns are the greatest (chart from BAML).

Weekly Market Summary

After making bull market highs last week, equities lost 1% this week, led by small caps (RUT) which shed another 2.4%. With RUT now down 8% from its July high and under its 200-dma, investors are starting to wonder whether a larger correction is underway.

One reason to expect a larger sell off is that that has been a pattern during mid term election years. As an example, in the past four mid-term years, SPX has sold off by 8%, 16%, 20% and 34%; from its high to its eventual low has taken 2-6 months.  In the past 6 months, the largest correction was 4.5% and took just 11 days.

Quartz: The 22 Best Twitter Feeds You Should Follow

Many thanks to the people at Quartz for including us in their list of the 22 Best Twitter Feeds You Should Follow. The full list is here and includes heavy weights from BIS, the WSJ, Pew, The Economist, Reuters, Bloomberg, RBS, Credit Suisse, Dealogic, Business Insider and others. We're honored.

Buy SPX on the Death Cross in RUT

We discussed weakness in RUT over the weekend. Our conclusion was that relative strength or weakness in RUT in the past has been an inconsistent indicator for the broader market (post).

This is consistent with a prior post where we analyzed significant market corrections and found no reliable relationship between market tops and the relative performance of RUT and NDX (risk indices) versus the SPX and DJIA (large cap indices; post).

The chatter in the market now is that RUT is experiencing a "death cross", where its 50-dma is crossing below its 200-dma. The conventional wisdom is that this indicates weakness in trend and is therefore bearish. The contrarian point of view is that many "death crosses" coincide with good buying opportunities. So, which is it?

The evidence for the contrarians looks more compelling on first glance. The vertical lines are each death cross (lower panel) in the past 20 years. More often than not, RUT (top panel) moved higher in the months after a death cross.

If you look more closely, you will notice that RUT only moved lower after death crosses in 2000-02 and 2007. These were bear markets. In other words, buying the death cross in RUT worked because the broader market was in a bull market (1995-1999; 2004-06; 2010 and on).

Weekly Market Summary

SPX, DJIA and NDX all ended the week at new highs. For them, the trend remains higher.

What is most interesting is the small cap index, RUT. Not only did it lose 1.2% this week while the other indices gained, but it is now more than 5% off its peak. For the year, RUT is negative and SPX is up 9%.

Is this divergence between SPX and RUT bearish? It would seem it should be. When small caps underperform, it indicates weakness in breadth as investors concentrate their buying in a relatively small number of large companies.

The problem is these divergences have usually not been bearish in the past few years. The yellow highlights below are times when small caps underperformed large caps (lower panel). Each time, SPX continued higher (top panel). The main exception was in 2012 (in orange).

Moreover, there were several instances where small caps outperformed large caps right into a market peak (shown with arrows). If anything, that has been a better predictor of trouble for SPX. Why would this be? When small caps outperform, investors are chasing performance. It's a beta chase, and this indicates exuberance. At an extreme, this exuberance is punished with a market correction.

Why Late 90s Euphoria Is Not Coming Back

A recurring meme in the stock market is that retail investors today are not as enamored with equities as they were in the late 1990s. The softly spoken corollary is that until we see that level of euphoria, stocks will continue to rise unabated.

If you missed the 1990s, here are two personal anecdotes to describe what it was like:

1. Online trading services like E-Trade were brand new. Our firm was hired to advise one such company in 1998. During the course of several focus groups, former policemen and teachers described how they had left their jobs to day trade. But it wasn't just their own capital; they were also trading the savings and retirement accounts of their neighbors and family members.

2. In late 1999, we sat down with the CEO of mid-sized technology firm in Silicon Valley. As the meeting started, the CEO bought stock. Two hours later, he sold for more than a million dollar gain. The next week he used that money to pay 30% over the ask for a $4 million property in Atherton. He razed the nearly new house on the lot three months later.

Imagine this: the Nasdaq nearly tripled between 1996 and 1998. Then, in the next 18 months, it quadrupled. How do you think that impacted investor psychology?

That was the investment climate attracting former policemen and teachers to day trading. In comparison, the market's 60% rise since the start of 2013 seems rather drab.

There was a legendary IPO frenzy in the late 90s. Theglobe.com went public in November 1998 at a price of $9. On the first day, it traded up to $97. Side note: by 2000, it was trading at 10 cents.

VA Linux gained 700% on its first day of trading in December 1999. The company was valued at $9 billion. The year before, Linux had $5 million in sales and earned a total of $84,000 in profits.

Why The Economic Recovery Has Been So Slow

Many market watchers continue to express surprise over the modest pace of recovery in the US economy since 2009. Are they right to expect growth to have been more robust?

The short answer is no.

The 2008 recession is not comparable to other downturns since the end of World War II. Therefore, expecting the recovery to track the pace of prior recoveries is misguided.

With few exceptions, post-war recessions have primarily been led by inflation and monetary tightening. Some of these came as a result of war: the Korean War in the 1950s and the Vietnam War in the 1960s, when government spending contributed to price hikes. In the 1970s and early 1980s, the primary cause for inflation were sharp spikes in the price of oil. To a lesser degree, that was also the case in 1990.

While 2000-02 is remembered now for the substantial fall in equity prices, the economic downturn was actually mild. The dot-com bubble had burst and then 9/11 took place. But GDP contracted by just 0.3% and unemployment peaked at just 6.3%. It was a stock market recession more than an economic recession.

The economic contraction in 2008 was nothing like any of these recessions. Inflation and monetary tightening had nothing to do with the recession: core CPI peaked at just 2.5%.

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

First, here is a quick recap of the story over the past few months:

Fund manager equity allocations reached an extreme in July. At +61% overweight, it was the second highest since the survey began in 2001. This was a clearly identified risk to near term equity performance (post).

In early August, the Euro 350 dropped 8% and SPX dropped 5%. In response, equity allocations fell to +44% overweight.

Moreover, fund managers moved to cash, with cash levels shooting up to 5.1%, also an extreme. As we specifically noted a month ago (post), this was a strong positive: cash above 5% has been close to equity lows in 2002, 2003, 2011 and 2012 (green shading).

Which brings us to the current survey of fund managers' positions. SPX and the Euro 350 rose more than 5% in the past month. Fund managers have responded by raising their global equity exposure to +47% overweight and reducing their cash to 4.6%.

Business Insider: Top Finance People to Follow

Many thanks to the people at Business Insider for including us in their annual list of the Top Finance People to Follow for a second year. The full list is here.

Weekly Market Summary

Today's widely anticipated employment report (NFP) reaffirmed that growth remains positive but tepid. 142,000 jobs were added in August, well off the expected print of 220,000 new jobs.

Was this "miss" really a surprise? No.

This month's print follows those of 84,000 in December and 288,000 in June. Moving between extremes like these is nothing new: it has been a pattern during every bull market. Since 2004, every NFP print near or over 300,000 has been followed by one near or under 100,000 (circles).

We should also note that a "miss" of 80,000 jobs is equal to 0.05% of the US workforce. Assuming greater forecasting precision is folly.

The largely ignored bigger picture is more instructive. In the past 12 months, NFP has averaged 207,000. That is close to the middle of the range in the chart above.

September Macro Update: Trend Growth of 2% Real

In May we started a recurring monthly review of all the main economic data (prior posts are here).

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 and profit expansion and valuation levels.

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

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

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


Employment and Wages
The August non-farm payroll (142,000 new employees) was at the lower end of a 10-year range. (The past 12-month average of 207,000 was, on the other hand, right in the middle of the range). This follows prints of 84,000 in December and 288,000 in June. Moving between extremes like these is nothing new: it has been a pattern during every bull market. Since 2004, every NFP print near or over 300,000 has been followed by one near or under 100,000 (circles).

Weekly Market Summary

The 2Q earnings season is over. Per Fact Set, earnings grew at 7.7% yoy and sales grew 4.5%. These are the strongest results in several years and, remarkably, they are coming when the bull market is already more than 5 years old.

The sales growth rate was particularly strong. Analysts had expected 3.7% in 2Q. The consensus forecast for 3Q and for the full-year are still for 3.7%; so, some moderation is expected.

The recent macro data supports growth of 3.5% to 4.5% in sales. But it shows a curious lack of accelerating growth after the winter slump.

Real personal consumption (PCE), which comprises about 70% of GDP, grew at annual rate of just 2% in July. There had been a post-winter pop to 2.5% in March, but the rate of growth has declined every month since then.

These figures are inflation-adjusted. Adding a 1.6-2% deflator yields a roughly 4% annual growth rate in nominal terms, equivalent to the sales growth rate expected for SPX in 2014.