Weekly Market Summary

Summary: Waterfall events like the current one tend to most often reverberate into the weeks ahead. Indices will often jump 10% or more higher and also attempt to retest the lows.  Volatility will likely remain elevated for several months. But the fall in equity prices, which has knocked investor sentiment to its knees, opens up an attractive risk/reward opportunity for investors. Further weakness, which is quite possible, is an opportunity to accumulate with an eye toward year-end. However, a quick, uncorrected rally in the next week or two would likely fail.

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Equities ended the week higher: SPY and DJIA rose 1% and NDX rose over 3%. Outside the US, Europe gained 1% and EEM gained 3%. The biggest mover was oil, which gained 12%.

The last two weeks have been remarkable. On August 17, SPY closed less than 1% from its all-time closing high. A week later it had lost 11%. And then three days later it had regained half of those loses, jumping 6%.

A drop that much, that quickly, is very rare. According to David Bianco, it has happened only 9 times in the more than 20,000 trading days in the past 80 years. All of these occurrences were precipitated by (perceived or real) political or economic crises.

Weekly Market Summary

Summary: Strong downward momentum usually has follow through. US indices are mostly within a few percent of significant support levels. The selling this week registered noteworthy extremes in breadth, volatility and sentiment. Friday probably will not mark the low, but risk/reward over the next month looks favorable.

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For the week, SPY and DJIA dropped 5.6%, NDX 7.4% and RUT 4.6%. For SPY, it was the biggest weekly decline since August/September 2011 and May 2010.

These numbers tell you that the decline this week was primarily about large cap stocks. Not only did small cap stocks outperform but small companies within SPY outperformed larger ones.

Investors will come up with any number of reasons for the sell off. To us, the most important aspect is this: 80% of the selling over the past two weeks has taken place overnight. In fact, before Friday, cash hours showed a gain over the prior 8 trading days. SPY has lost $9.30 overnight since August 10. That date corresponds to the decision by the PBoC to allow the Yuan to depreciate, which set off a cascading effect in other currencies.

There have been few earnings catalysts during this selloff, as most companies have finished reporting 2Q results. Macro data has also been light and positive: housing starts rose to a new 8 year high and retail sales recovered to post a 2.3% annual gain in real terms in July.

The FOMC, meanwhile, remains divided on whether to raise rates in September. The probability of such a hike fell this week, but it is still higher than it has been for any other month in the past.

That the main catalyst for the selloff was events outside the US suggests that the selling is more likely to be relatively short-lived and contained.

Let's look at an example. At its worst, the 1997 Asian financial crisis, which involved currencies throughout the region losing 50% of their value and large loan packages from the World Bank and IMF, resulted in SPX losing only about 5% over two weeks in August. SPX remained in choppy turmoil the remainder of August, then rose 8% in September. The crisis spread over the coming months, but the downside never expanded and the overall trend in SPX was higher.

Fund Managers' Current Asset Allocation - August

Summary: Overall, fund managers' asset allocations in August provide conflicting views on sentiment.

On the one hand, fund managers' cash remains at the highest levels since the 2011 and 2012 equity lows and the panic in 2008-09. This is normally contrarian bullish.

However, allocations to equities rose over the past two months and are above the mean. Cash levels are high because fund managers are underweight emerging markets, US equities, commodities and bonds. In August, their exposure to European and Japanese equities increased.

Moreover, fund managers remain very overweight "risk on" sectors: allocations to discretionary, banks and technology are well over their means. Allocations to defensive sectors, like staples, are near all-time lows.

Net, this is not the sentiment profile of investors who are fearful.

Regionally, allocations to the US and emerging markets are at very low levels from which they normally outperform on a relative basis. The dollar is also considered highly overvalued, and BAML fund managers have been prescient in the past in calling turning points in the dollar.

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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 2014, and stocks have subsequently sold off each time. Contrariwise, there were some relative bearish extremes reached in August and October 2014 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 cash levels remained over 5% for a second month, the first time it's been this high for two months in a row since early 2009. This is an extreme and it's normally very bullish for equities (green shading). Note that cash levels haven't been much below 4.5% since early 2013.  

How Asset Classes Have Responded To The First Rate Hike

Summary: How have different asset classes in the past responded when the FOMC has raised rates for the first time? Commodities were the best performing asset; they boomed.  The dollar sold off. Equities usually rallied into the decision, then sold off, and then rallied again. Treasury yields rose. The total return for high yield bonds was usually positive.

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On September 17, the FOMC will meet. And expectations are that the Fed will enact a 25bp rise in rates. This would be the first change in rates since December 2008, and the first rise in rates since June 2006 (here).

The question for investors is: how might various assets classes react? To answer, we can look at how they have reacted in the past.

Before looking at the data, consider this: a rate increase means that the economy is improving enough that employment and inflation are considered to be well on the path to being healthy. You would expect, therefore, that stocks would do well if the Fed felt comfortable raising rates. An improving economy also implies demand for commodities and lower default rates, meaning that commodity prices are rising and high yield bonds are at least stable.

And in fact, this is what usually happens when the Fed raises rates for the first time: stocks and commodities rise and high yield bonds have a positive return over the next year (the average length of time rates rose). The chart below covers the period after the first rate hikes in 1983, 1986, 1988, 1994, 1999 and 2004 (data from Allianz).

Weekly Market Summary

Summary: Price action in US equities is weak. Two potential opportunities to kick off a rally failed this week. Despite this, short term sentiment and seasonality support a move to the upper end of the range. Ultimately, lower lows are still ahead over the coming weeks.

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US equities had two opportunities to kick off a rally this week. Neither had much follow through.

On Monday, positive breadth was 89%; days like these typically indicate strong buying interest among big investors and thus the initiation of a rally. The most recent ones were in October and December 2014 and January and February 2015, and equities rose higher each time. This one failed the next day, giving back all the gains. The last time this happened, at a low, was in the turbulent summer of 2011.

Why High Yield And Equity Markets Have Diverged

Summary: The apparent divergence between credit-risk, as seen in rising high-yield bond spreads, and equities is due primarily to the 60% drop in oil prices over the past year. There's been no remarkable rise in spreads outside of energy; these are back to being in-line with the long term mean after falling to a 7-year low in 2014. If commodity prices continue to fall, this will be a meaningful metric to watch for equity risk.

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Spreads on high yield (junk) bonds relative to treasuries have widened. This implies heightened credit risk. The widening and narrowing of spreads is correlated to equity performance over time. Since mid -2014, these have diverged (data from Gavekal Capital).

There's No Carnage Under The Surface of the Indices

Summary: Some stocks are doing well, and some are doing less well. On average, stocks are higher over the past year and are not far off their 52-week highs. This comes after the average stock has risen 80-100% over the past 3 years. There's no widespread carnage being hidden by the indices during the current period of sideways trading.

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Over the past year, the S&P index is up 7%, the Nasdaq 100 is up 14% and the Russell 2000 is up 6%. Since the start of 2015, those gains are 1%, 7% and 0%, respectively.

With a choppy trading range so far in 2015, are the indices hiding widespread carnage under the surface? In other words, have most stocks fallen hard and their losses hidden by a few winners? The short answer is no.

To be clear, some sectors have been hard hit. From their highs, energy companies have fallen an average of 25%. Material stocks have fallen an average of 15%. And clearly small cap companies in the Russell have been much harder hit than large cap stocks in the other indices.

But other stocks have gained, especially in the healthcare, consumer discretionary and financial sectors. So how have stocks performed on average?

Most stock indices are weighted by market capitalization, so larger companies have a disproportionate influence on the index's gains and losses. By looking at equal-weighted indices, in which every company has the same influence, we can see how an average stock has performed.

Starting with the S&P, the average stock is up 6% in the past year and flat for 2015. Since their 52-week high, the average stock is down just 3%. Keep in mind, the average stock in the S&P has risen 80% in the past 3 years.

Update: What To Look For When The Price Of Oil Has Bottomed

Summary: the price of oil has fallen 30% in a month and is still forging new lows. "Smart money" thinks the low is near, and "dumb money" sentiment is at a 15 year trough, so it possible a reversal could arrive soon. However, the best approach for investors is to first wait for a sign that big buyers are interested: look for a "higher low" in price and for the downward momentum to dissipate. Neither of these has happened yet. This was the pattern at other major lows in oil.

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In February, we took a look at prior times over the past 30 years when the price of oil had fallen by more than half (here).

Our conclusion was that oil had probably not bottomed. In the event, oil formed a low a month later, in March, from which it rallied nearly 50%. It has since fallen all the way back to its prior lows.

So, what happens next? Right now, there is no clear indication that price has bottomed.

We previously drew several conclusions about what to look for at price bottom. The current price pattern is similar to two other instances. Let's review each one.

In 1986, the price of oil fell sharply and quickly, just like it has in the past year. The first rally failed near the 50-dma (blue line; arrow). Price retested the low the following month, then rallied into May before retesting the low again 4 months later in July (second circle).

The Impact of Oil and the Dollar on 2Q Financials

Summary: 2Q financials have been poor, with negative growth in both sales and EPS. Sales growth has been affected by a 50% fall in oil prices and 15% fall in the value of trading partner currencies. Both of those are likely to make upcoming 3Q financials look bad as well.

Of note is that profit margins are still expanding for most sectors.

Looking ahead, perhaps the biggest wildcard is the dollar, which historically weakens after interest rates start rising. This would be a boon to the roughly 40% of S&P sales and profits that are derived from overseas.

Especially for their rate of growth, S&P valuations are high. Even if sales and EPS growth start to pick up, valuations are likely to remain a considerable headwind to equity appreciation.

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About 87% of US corporates have reported their financial results for the 2nd quarter of 2015. What have we learned?

Using figures from FactSet, EPS growth in 2Q is tracking minus 1.0% (year over year) versus an expected growth rate of minus 1.9% on March 31st when the quarter began; sales growth is tracking minus 3.3%, exactly as expected when the quarter began.

Although EPS turned out to be better than expected while sales met expectations, neither result is impressive as both are down from last year.

By now it should be no surprise that the energy sector has been hard hit by falling oil prices. The average price of oil was over $100 in the 2Q of 2014; it fell 50% to an average of roughly $55 in 2Q of 2015.

August Macro Update: A Recession Is Not Looming Ahead

Summary: This post reviews the main economic data from the past month.  Most, but not all, of the data was positive:

• Employment growth is the best since the 1990s, with an average monthly gain of 243,000 during the past year.  
• Compensation growth is positive but not accelerating: 2.1% in 2Q15.
• Personal consumption growth the last two quarters has been the highest in 8 years: 3.1% in 2Q15.  2Q15 real GDP grew 2.3%, near the upper end of the post-recession range. 
• Housing starts are near an 8 year high. New home sales in June rose 18% yoy. 

The main negatives are:

• Core durable goods growth fell 3.5% yoy in June. It was weak during the winter and there has been little rebound since. Industrial production is also weak, growing at just 1.5% yoy, one of the low rates in the past 15 years.
• The core inflation rate remains under 2%. It is near its lowest level in the past 3 years.  

Bottomline: the trend for the majority of the macro data remains positive. The pattern has been for the second half of the year to show increased strength.

Prior macro posts from the past year are here.

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Our key message over the past year has 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 July non-farm payroll was 215,000 new employees. In the past 12 months, the average gain in employment was 243,000, 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. The low print of 119,000 in March fits the historical pattern.

Insiders Are Bullish While Outsiders Are Bearish

Summary: Corporate insiders are bullish equities at precisely the same moment that outside investors have become bearish. Other factors may intervene to drive the price of equities lower. But sentiment, at least short-term, is quite clearly biased in favor of higher prices.

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There's a marked divergence of opinions in the US stock markets at the moment.

On bearish side are equity investors. The ISE equity-only call/put ratio has closed below 100 in each of the last 3 days. This means equity investors are buying protection against falling share prices to an extreme degree. In other words, they are bearish and this is normally a positive for equity prices.

This ratio has only twice before closed below 100 three days in a row: mid-March and mid-November 2008. In both cases, the S&P was near a short-term low and rose over 10% in the weeks ahead. Both of those rallies later failed.

Weekly Market Summary

Summary: There are several breadth and sentiment indicators that suggest the indices have reached, or are near, a one month low. But more importantly, for the first time in awhile it is possible to see an endgame to the sideways trading range that has persisted in 2015. A break lower soon, should it occur, would likely lead to a washout low. This is the set up for US equities as seasonally weak August begins.

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Our view at the end of 2014 was that 2015 was likely to be unremarkably flat. This was to be a year where stock appreciation would take a break while sentiment and valuations cooled off and the economy improved (post).

Sideways markets are not unusual. Periods like the one we are in now can last as long as two years. There is no decisively bearish implication of a sideways market either. It is, in fact, a pattern that is common within every bull market, a period of rest between periods of rapid price appreciation. We reviewed this topic in detail here. Similar instances to today are shown below (this and all charts expand when clicked).