Friday, September 11, 2015

Weekly Market Summary

Summary:  It's never perfect in equity markets; when price patterns and breadth look healthy, sentiment is overly bullish and further appreciation becomes limited. When price falls, the price pattern looks scary and breadth looks terrible but sentiment becomes too bearish. These are when longer term lows form. More likely than not, that is where equity markets are now.

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The bottomline on the markets right now is this: waterfall events (like late August) tend to reverberate into the weeks ahead, with indices rallying 10% and also retesting the lows. We are probably still in the middle of this period and it's not hard to imagine that it will continue into October.  The increase in volatility makes short term activity subject to wild reversals, exactly as we have seen over the past 3 weeks.

On a year-end view, the washout in breadth and bearish sentiment provides an attractive risk/reward to accumulate equities on sell offs. With FOMC and OpX upcoming, the next two weeks might provide another opportunity to do so. All of this assumes, as we do, that equities are not in the process of starting a bear market, but simply correcting within the context of an ongoing bull market.

The fall in equities has a majority of investors concerned that a bear market is unfolding. This is not surprising: every significant drop in equities makes price patterns look scary, breadth look terrible and brings out stories in the media emphasizing the risks of investing. All of this explains why sentiment during corrections gets knocked down to its knees, as it has been now. The twist is that this is how every new uptrend in a bull market begins.

US equities have risen 80-100% in the past 3 years, and indices have been higher every year for six years in a row. To date, US equities are trading about 5% lower in 2015. This weakness in the midst of a bull market is not unusual.

Highlighted below (in yellow) is the annual return during every bull market in the past 60 years (non-highlighted years are bear markets). In red are years with low returns. Low returns and losses are a feature of every sustained bull market. 2015 is likely to be one of those years, but that does not imply that the bull market has ended.

It would be, in fact, unusual, if the current 'correction' led straight into a bear market. After a long uptrend, the first loss of more than 10% (arrows) has not been the start of a bear market (vertical lines). The trend usually weakens first. A better bet would be that a retest of the May-July highs, that fails, would set up a bear market. That retest hasn't happened yet.

To be clear, the current trend is weak. It's hard to argue against stepping aside and allowing weakness to play out. This is how pure-trend followers currently view the market. SPX is below its 200-dma and that moving average is beginning to inflect downwards. That obviously happens in every bear market. But it also happens throughout every bull market (highlights). On it's own, this does not imply the worst outcome is most likely one.

The recent "death cross" in equities, where the 50-dma crossed below the 200-dma, also does not indicate a bear market. In fact, a trader who had followed that signal would have lost money over time. "Most of the time, the death cross turns out to mark nothing more than a moderate correction" (data from Rob Hanna).

Is the current bull market doomed due to old age?

True, the current bull market is the third longest since the 1930s, but those cycles have been getting longer. It's the fourth largest bull market by percentage gain. But it also comes after the worst bear market in 80 years, so a longer and larger recovery on its own doesn't imply an imminent end. To be clear, however, this bull market is much closer to its ending than its beginning.

As we have said in recent posts, bull markets normally end when either (or both) sentiment/valuation reached an extreme and/or a recession begins.

Our view is that the economy is not nearing a recession: employment growth is the best since the 1990s, housing demand is the best in 8 years and household balance sheets are among the best of the past 30 years (chart below). It's not all perfect but the balance of evidence is positive (a recent post on this is here).

It's hard to say that transportation data supports the view that the economy is weakening. Rail volumes are at new highs and trucking volumes are near prior highs. Both of those were clearly weakening into the last recession (data from Yardeni).

Consumer discretionary spending is strengthening. Vehicle sales are at a new 9 year high. Restaurant demand is near its 10-year highs. Again, into the last recession, the trend was markedly weakening (data from Calculated Risk).

Non-residential construction is up 18% yoy and construction of new factories is reaching new all-time highs. This is not the profile of an economy sliding into a recession (data from Yardeni).

The Eurozone is not growing rapidly, but it is growing; PMI is at a 4 year high. Fears of a recession in this other major developed economy do not appear warranted either (data from Markit).

Sector relative strength before and during the recent sell off agrees with the macro data. Typically, money flows away from aggressive (cyclical) sectors on a relative basis as the economy weakens. Not this time.  Consumer discretionary, financials and technology sectors have all outperformed (blue arrows). In comparison, all of those sectors underperformed into the start of the 2007-08 bear market (red arrows). To the extent that the stock market anticipates economic weakness before it occurs, it hasn't done so this time (data from Tom Bowley; more on this here).

Overvaluation and excessively bullish sentiment were both valid points in 2014. But the sideways to lower trading this year has changed both of these for the better.

Trailing PEs are still above average but are returning to the range that prevailed during most of the prior bull market (yellow; data from FactSet).

The trailing PE ratio is being elevated by the 50% fall in energy EPS (which makes the index look more overvalued).  Those PEs, however, are also being understated by high margins (which make the index look less overvalued). On a price/sales basis, which corrects for margins but not for the fall in energy revenues, the index is still firmly overvalued. This would seem to be a headwind to further equity appreciation until revenue growth begins to accelerate (data from Yardeni).

Meanwhile, investor sentiment has become outright bearish. There are many ways to measure this but perhaps the most direct is fund flows. Over the past 3 weeks, outflows from US-only equity funds has been -$17.8b, +$3.9b and -$14.3b. These are massive outflows. During this bull market, the only comparable period is March 2009 and August 2011. In the latter case, SPY was more than 10% higher by year-end (data from Lipper and Sentimentrader).

What is especially remarkable about these fund outflows is that equities have not even retested their original lows from 3 weeks ago. In other words, investors are selling even as price has made higher lows. This is a positive.

The Citibank Panic/Euphoria model indicates that investors are at 'panic' levels. The most recent comparable times were June 2012 and October 2011, both lows in equities. When 'panic' has been at current levels in the past 30 years, equities were higher 12-months later 96% of the time (blue shaded areas).

What is noteworthy about this model is that it distinguishes bull and bear markets: note the 2000-02 and the 2007-08 bear markets were not periods where the model indicated 'panic'. Again, an unfolding bear market does not seem likely.

So, how does the stock market resolve, on the one hand, positive economic data and bearish investor sentiment with, on the other hand, overvaluation?

One parallel is the DJIA after the 1990s. Everyone remembers the Nasdaq falling by more than 60% in the year after its 2000 peak, and then falling another 30% into its 2002 low. For 1 1/2 years, until early 2001, the Dow just traded sideways, working off its overvaluation. It wasn't until NDX fell 50% in a 3 month period in 2001 that the Dow entered into a bear market - more than a year after it had peaked.

A vicious 25% bounce followed, and that put the index back near its all-time highs by mid-2001. Real GDP was at an all-time high in 2Q 2001. Until this point, it wasn't an economic recession, it was a bear market brought on by overvaluation that the Dow, at least, was digesting by going sideways. The 9/11 attack pushed the index back into a bear market (arrows in the chart above).

There is a recent precedent, in other words, for the indices to continue to move sideways well into 2016, rising on excessive bearish sentiment but failing to make material new highs due to overvaluation. If the economy continues to improve, as it has been, then this seems like a likely scenario for the year ahead.

The FOMC meets on Thursday to possibly announce the first rate hike since 2006. This decision likely dominates trading in the week(s) ahead. A decision to raise rates seems unlikely to us, for two reasons.

First, FOMC members as well as close watchers of the Fed are divided on whether the Fed will act in September. The Fed will not want its rate decision to come as a surprise, yet a decision to raise rates next week would be. It's decision to raise rates in 1994 also came as a surprise, and markets reacted unfavorably. With markets already unbalanced, a surprise decision to raise rates seems unlikely (data from Allianz; more on this topic here).

Second, a clear cut case for raising rates is missing. The strongest growth data is employment, yet wages are still growing at just 2%. Moreover, it's not at all clear that unemployment of 5.1% (blue line) represents a level at which core-inflation will rise (red line): core-inflation fell further after reaching this level of unemployment in 1989, 1996 and 2005. Total inflation is currently just 0.2%.

As noteworthy is that wage growth (green line) was accelerating when unemployment reached 5.1% in 1989, 1996 and 2005. There was good reason to believe inflation would pick up. In the current situation, wage growth has been decelerating. That might well change, but a data-dependent approach, when CPI is 0.2%, would be biased to waiting for wage growth to accelerate first.

Economist David Rosenberg believes that inflation is more likely to become a factor when unemployment is nearer 4%. The current data appear to support that view.

To add further zest, options expire next week. September OpX has a positive bias. Should that play out again this year, note that the week after is solidly weak. This also fits the seasonal pattern of a typically weak end to the month of September (data from Chad Gassaway).

The larger context, again, is that indices are in the middle of the post-waterfall recovery, where lows can be retested a month or more later, interspersed with rallies of as much as 10%. The range is wide and loose. More on this pattern here.

Within this context, indices have so far held up well: 3 weeks after their initial fall, none has revisited their original low.

NDX is leading higher. It is at the prior floor to a 6-month trading range. Our expectation was that resistance would be where investors were left surprised by the fall and therefore eager to sell at breakeven. The August 21 gap (highlight) has so far been a selling area; on strength, the next one is the long August 20 candle (arrow).

SPY is a step behind NDX. Should indices show strength in the week ahead, the August 21 gap (highlighted) at the prior floor of its 6-month trading range should bring out very strong selling. For now, 202-204 should cap upside. Post-FOMC and/or post-OpX weakness that returns SPY to 185-190 is a high interest range for accumulation with an eye on year end. It's a wide range, but that is consistent with Vix remaining well above 20.

Our weekly summary table follows.

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