Weekly Market Summary

Summary: The trend in US equities remains higher. But momentum is very weak and breadth suggests the uptrend is running on fumes. This is the set up as we enter June, one of the weakest months of the year for equities.

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For the week, SPY lost 0.8% while NDX and RUT lost 0.4%.

Even with minor losses, SPY gave up all of its gains from the prior 3 weeks. Recall, the market had gained in each of those 3 weeks, which illustrates just how shallow the advance has been.

Just 18 points separates the past 6 weeks' closes in the S&P (2118, 2108, 2116, 2123, 2126, 2107). 5 of these 6 closes are separated by less than 0.5%.

Financials, which had closed at a 7 year high a week ago, lost 1.2% this week; that's not a lot but it was enough to put the sector back to where it was trading in early December.

In short, upward momentum has been very weak, a situation we think is likely to persist until there is a more complete washout in breadth and a reset of sentiment.

Let's discuss a possible short term set up and then the longer term picture.

The more than 1% fall on Tuesday and then rise on Wednesday created a lower high. The market traded down on both Thursday and Friday. This looks like a corrective A (down), B (up) and C (down) pattern. If so, the target is the 209-210 area. The strong down momentum created on Tuesday appears to still be in the process of dissipating, a typical pattern we discussed this week here.

New Highs In Cumulative A/D Is Not Confirmation Of A Healthy Market

Summary: Cumulative advance-decline (A/D) is one of the most popular ways to measure market health using breadth data. But cumulative A/D has given no warning before any drop in equities of 5% or more since the 2009 low, including the 20% drop in 2011. That cumulative A/D made a new high last week is not confirmation that the underlying market is healthy.

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In September 2014, the cumulative advance-decline (A/D) line for the S&P hit a new high. A month later, the stock index was down 10%.

Twice in December 2014 and again in February 2015,  the cumulative A/D line hit new highs and within two weeks the stock indices lost 5% (twice) and 4%.

Among the ways of measuring market health, this is one of the consistently least useful. There are two big problems with it.

The first is conceptual. Cumulative A/D takes the number of stocks moving up on a day and subtracts the number of stocks moving down. That sum is then added to yesterday's total.

If a lot of small stocks move up by one penny on low volume but slightly fewer large companies move down a dollar on high volume, the cumulative A/D line moves higher.  Or, if a large number of defensive stocks move up while "risk-on" cyclical stocks move down, the cumulative A/D line moves higher. Neither one of these is a healthy sign.

The second problem is empirical. Every fall of 5% or more since the 2009 low has started from a new high in cumulative A/D. This includes several 10% declines and the 20% decline in 2011. It's hard to be enthusiastic about a measure of stock market health that gives no warning before a 20% fall in equities. These instances are shown below below (cumulative A/D in top panel and the S&P in the lower panel; the zig zag is set for declines greater than 5%).

Tuesday's Sell Off Low Likely To Be Retested

Summary: Yesterday, stocks fell more than 1% on intense selling pressure. Trin spiked over 2 for the first time since early March. Declining volume was more than 8 times more than advancing volume. It would be very unusual for that level of selling pressure to dissipate immediately. More likely, Tuesday's low will be retested in the days ahead.

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On Tuesday, US equities sold off hard. The S&P dropped more than 1%. Of significance, selling pressure was intense: declining volume on the NYSE was more than 8 times greater than advancing volume, the highest since late January.

Moreover, Trin (also called the Arms Index) closed above 2.0 yesterday. Trin is a breadth indicator. It is derived by dividing the advance-decline ratio for issues by that for volume. A close over 2 means that down-volume was twice down-issues; in other words, stocks fell on relatively high volume.

A spike higher in Trin like yesterday's can often be near a low in the equities market. That is especially true if the market has been selling off for a week or more. In this case, a high in Trin marks capitulation. A relevant post on this indicator is here.

This makes today's action noteworthy. The S&P gapped up overnight and then rose nearly 1%; the Nasdaq rose 1.6%. Yesterday's low was not retested.

It would be unusual if Tuesday's low remains uncontested in the days ahead. Down momentum like yesterday's almost always takes more than one day to dissipate.

Let's look at recent examples.

The first chart looks at the past year: the S&P is in the top panel, Trin is in the middle panel and declining volume relative to advancing volume is in the lowest panel. Every instance of a Trin spike higher involves at least one lower low in the S&P, even if it came after a strong bounce like today's (note September 2014 and January 2015).

A Set Up For Volatility To Soon Rise

Summary: The S&P index is making new highs. The trend is higher. But in the process, the trading range has become very tight. In the past, this has been followed by higher volatility and limited near term upside for equities.

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Over the past five weeks, the trading range for the SPX has contracted dramatically. Just 18 points separates the last 5 weeks’ closes (2118, 2108, 2116, 2123, 2126). 4 of these 5 closes are separated by less than 0.5%.

Moreover, the range between the weekly open and close for SPX the last 4 weeks has been 11 points,  6 points, 7 points and 5 points. That averages to a mere 0.3% open/close range each week.

Periods of contraction in the market are typically followed by expansion during which volatility increases. Presented below are several studies that suggest this is likely over the next week or two.

First, Salil Mehta of Georgetown notes that SPX has gone 8 days without a 1% intraday decline from a high. Streaks this long are rare and typically end after 9 days, meaning that a 1% decline is due next week. This implies an intraday visit to roughly the 2100 level is ahead (his post is here).

GDP Seasonal Adjustment: There's No Smoking Gun

Summary: First quarter GDP growth was stronger than originally estimated. When adjusted for seasonality, the economy grew 1.8%, which is consistent with the average growth rate over the past three years. It is also consistent with a wide variety of economic data (employment, wages, housing, consumption) released in the past several months. And, finally, it is consistent with the message being sent by the treasury market.

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This week, the Bureau of Economic Analysis (BEA) announced that it would be revising the seasonal adjustment methodology it uses in estimating quarterly GDP.  For anyone following US macro data, this announcement was of no surprise (read further here and here).

For at least 15 years, the BEA's methodology has consistently underestimated first quarter GDP. If BEA's methodology worked perfectly, first quarter seasonally adjusted real GDP growth should not be consistently higher or lower than growth in any other quarter.

That the methodology needed revising was obvious. First quarter GDP was 1% lower than the remainder of the year from 2000-10 and 2.3% lower from 2010-14 (data from the SF Fed; full post here).

Investor Opinions Have Become Extremely Uniform, And That's Not Good

Summary: Investor opinions have become extremely uniform. By some measures, they are the most uniform in 25 years. In the past, this has corresponded to a period where equities have lacked significant upside momentum. That appears to be a quite likely outcome until investors become more varied in their market outlook than they are today.

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Last week, the number of investment advisors who are bullish US equities dropped below 50%. For many, this was seen as sign of bearishness.

Indeed, relative to the past 16 months, investment advisors were relatively bearish, to the point where the S&P has had a strong tendency to move higher in the ensuing weeks (yellow shading; chart from Investors Intelligence).

Fund Managers' Current Asset Allocation - May

Summary: In May, fund managers reduced their cash to 4.5%; in 7 of the 8 times cash has been at this level (or lower) in the past two years, SPY has fallen the following month, usually by around 5%. Allocations to equities are near their highs but mostly because fund managers are about 1.4 standard deviations overweight both Europe and Japan. In comparison, they are nearly 1 standard deviation underweight the US. In the past, this has been a set up for US equities to outperform on a relative basis.

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Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b 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.

To this end, fund managers became very bullish in July, September, November and December, and stocks have subsequently sold off each time. Contrariwise, there were some relative bearish extremes reached in August and October to set up new rallies. We did a recap of this pattern in December (post).

Let's review the highlights from the past month.

Fund managers reduced their cash levels to 4.5%. While this is relatively high on a historical basis, note that cash levels haven't been much below 4.5% since early 2013.   In other words, cash levels suggest fund managers are bullish, a contrarian warning.

Weekly Market Summary

Summary: US indices are in an uptrend. But what they have lacked is the ability to sustain upward momentum for more than a week or two. With SPY at a new ATH, another test of strength has again arrived.  There's room for price to move higher, but we suspect that any gains are likely to be short lived.

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SPY made a new closing high this week; the other indices did not.  For the week, SPY gained 0.4% while NDX and RUT both gained 0.8%.

Overseas markets, which had been leading the US until mid-April, are now well off their highs. European indices closed 1% lower this week. Emerging markets gained 0.6%.

Crude oil has been up 8 of the last 9 weeks but the gains the past two weeks have been minor. The trend higher has taken a pause.

Looking ahead, the main question once again is whether the breakout to new highs in SPY will hold. Over the past several months, they have not.

In short, we are back at the point where momentum has failed to carry the indices higher. Since the week of February 17, three months ago, NDX has not been able to gain even two weeks in a row. SPY has not been able to gain more than two weeks in a row. Both have a chance to change that pattern in the coming week.

The absence of follow through is most clearly seen on the weekly SPY chart. The trend is clearly higher but momentum has not been strong; in fact, RSI has only been higher once since the week of December 1 (top panel). In other words, momentum has now reached the level at which the SPY has been close to turning lower over the past 5-1/2 months.

Time to Sell Junk Bonds? Maybe Not

Summary: junk bonds (1) appear to be fairly valued relative to treasuries, (2) their underlying default levels are not ticking higher and (3) based on their short history, they will not likely lose value or markedly underperform equities once rates start to rise. Moreover, (4) investors have shown some panic in selling off the asset class over the past month.

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Jeff Gundlach is the new Bond King. Last year, when the consensus overwhelmingly expected US 10 year yields to rise over 3%, he said they would instead fall under 2%. In the event, they fell to 1.65% (read further here).

So he should be closely listened to when he says that investors should sell their junk bonds "on the day of the first rate hike." In the past 30 years, every time the Fed has raised rates (white line),  the spread between junk and 10 year treasuries has narrowed (yellow line). This means junk bonds are losing relative value (chart from Double Line; read further here).

The Misleading Read on Retail Sales

Summary:  A year ago, rail volume gave a misleadingly strong view of the economy. Now, plunging oil prices are giving a misleadingly weak view of the economy. It's unglamorous, but reality lies in-between.

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Retail sales bears are at risk of making the same mistake that railroad volume bulls made in 2014.

In 2014, the bullish view was that railroad volume was surging. This supported bulls' views that overall economic activity in the US was also surging.

Weekly Market Summary

What are the main threats to the equity markets and what oft cited concerns are likely less important. To answer this, here is a brief update on our overall views.

Technicals: The technicals for US equities are a concern. Price has been trendless since December. Moreover, each marginal new high has included fewer companies and each drop lower has stopped before what has, in the past, been a 'washout' low, i.e., a point where so many companies have been heavily sold off that a new uptrend begins. Ultimately, this pattern usually resolves to the downside. Read further here.

Macro: The US economy is not a source of concern. Employment growth over the past year has been the best since the 1990s and compensation growth is decent, at about 2.5%. Together, this should be a tailwind for future growth. To wit, the most recent GDP and personal consumption growth were among the best of the past 5 years.  And if consumption, which is 70% of the economy, continues to grow, companies will start to invest: right now capacity utilization is still under 80%, hence CapX has been low. To be clear, growth is not explosive like during the 1980s or 1990s, but it is positive. Read further here and here.

Financials: Corporate results are also not a big concern. Margins in 1Q expanded to a new high. The biggest drag has been from the energy sector and when their 60% decline is excluded, EPS for the S&P is growing at trend (about 8%). Sales growth is less, about 2-3%. Better US macro and ex-US macro will likely be tailwind for sales growth in the future. Read further here.

Valuations: That said, valuations are quite rich, especially on a price/sales basis. To our knowledge, they have almost never been higher. Valuation is a terrible timing mechanism but a good guess is that part of the reason the advance in equity prices has slowed this year is due to these high valuations. This will be a headwind for more rapid appreciation in equities, as it has been in the past. Read further here.

Sentiment: Sentiment is heady and a prime concern. A large majority of fund managers, investment advisors, active traders and retail investors are bullish and/or not bearish. This should not be a surprise as the last correction was 3 years ago. Together with valuation, this is probably the main reason equities are struggling to appreciate this year. Read further here and here.

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Understanding where headwinds to the equity market lie is not academic. If macro or financials were the main headwinds, we would expect this bull market to be near an end. That it has more to do with sentiment and valuation implies that a reset in equity prices (lower) will set up the next leg higher in 2015 and 2016. That would be the best set up. Of course, a long sideways pattern is always a frustrating possibility.

Our weekly summary table follows.

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May Macro Update: Employment + Wages = A Macro Growth Tailwind

A year ago, we started a recurring monthly review of all the main economic data (prior posts are here).

For most of that time, the consensus view has been that growth in wages and employment would soon accelerate and that this would lead to a meaningful increase in inflation above the Fed's 2% target. Our monthly review of the data has consistently shown this expectation to be premature.

The irony now is that economic data has seemingly turned negative over the past two months, to the point where many talk about a recession or QE4. We think this weakness is temporary, mostly driven by the huge drop in energy prices which has lowered inflation and depressed "nominal" price growth. "Real" growth remains positive.

More importantly, the fact that the consensus swings between extremes underscores how focused too many are on monthly data points, with the effect that underlying trend in the data is missed.

And the trend for the majority of the macro data remains positive.

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

• Employment: The average monthly gain in employment during the past year was 249,000, the highest since the 1990s. Annual growth in employment is the best in 15 years. 
• Wages: Wages have recently started to accelerate. The 1Q15 Employment Cost Index rose 2.7%, the highest since the recession.
• Demand: 1Q15 real GDP grew 3.0%, the second highest rate in the past 5 years. Real personal consumption (70% of GDP) grew 3.0% in 1Q15, the highest rate of growth in 5 years.  
• Housing: Housing starts data has been disappointing in February and March but housing sales and permits have been near 7 year highs.
• Inflation: However, the core inflation rate remains under 2%. It is near its lowest level in the past 3 years  

Our key message has so far been that (a) growth is positive but modest, in the range of ~3-4% (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.

Let's review each of these points in turn. We'll focus on four categories: labor market, inflation, end-demand and housing.


Employment and Wages
The April non-farm payroll (223,000 new employees) followed the disappointing 85,000 in March. Prior to March, NFP had been above 200,000 12 months in a row, the longest streak since 1993-95. April was therefore a bounce back to trend.

In the past 12 months, the average gain in employment was 249,000, the highest since the 1990s.

Monthly NFP prints are normally volatile. Since 2004, NFP prints near 300,000 have been followed by ones near or under 200,000. That has been a pattern during every bull market.  So while the March print of 85,000 was lower than expected, it fits the historical pattern. A low print was long overdue.

Weekly Market Summary

Summary: the trading range for SPY is tighter now than at any time since December before a 5% drop. SPY's trading range is likely to expand and, on balance, it seems more likely that the expansion will be to the downside rather than the upside. That has been the most common outcome in the past and there are a number of supporting reasons to suggest that it will be the case this time as well.

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SPY and NDX both made new highs on Monday, then proceeded to fall for most of the rest of the week. For the week, NDX lost 1.3% and SPY lost 0.4%. RUT was the clear loser, dropping 3.1%. 

Overseas was no better. Europe lost 3.4% and EEM lost 1.6%. 

Crude gained 3.2%. It has rallied 6 of the last 7 weeks. 

The pattern of making new highs and then giving back all of the gains continues. NDX has not been up two weeks in a row since mid-February. Over the last several weeks, SPY has lost 2%, gained 2%, lost 1% and gained 2% and now lost 2% into the past week's low on Thursday.

Through all of this, little progress is being made. For the first 4 months of 2015, SPY is up just 1.3%.

Despite the moves up and down, the trading range in SPY is now tighter than any time since mid-December before a 5% drop (lower panel). The time before that was in mid-September before a 10% drop.

Companies Are Doing Much Better Than 1Q Financials Show

Summary: Companies are doing much better than 1Q financial figures show. Energy sector EPS has fallen 60% in the past year; for the remaining 90% of the S&P, EPS is growing 7.5%. Only energy has seen a meaningful drop in margins; among the other large weighted sectors, margins are either close to flat or higher than a year ago. If oil prices can rise to $70 by the end of the 2015, the year over year impact of falling energy profit margins on total S&P EPS will become negligible.

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About 70% of US corporates have reported their financial results for the 1st quarter of 2015. What have we learned?

Using figures from FactSet, EPS growth in 1Q is tracking minus 0.4% (year over year) versus an expected growth rate of 4.2% on December 31st when the quarter began; sales growth is tracking minus 2.6% versus an expected rate of 1.6%.

These are horrible results, right? Actually, companies are doing much better than these figures show.

It should be no surprise that the energy sector has been hard hit by falling oil prices. The average price of oil was roughly $100 in the 1Q of 2014; it fell 50% to an average of roughly $50 in 1Q of 2015.  As a result, EPS for the energy sector fell by 60% and sales by 33% (data from FactSet).