In four different posts in August and September, we laid out how we expected this correction to evolve. You can read them here.
Not much has changed in our views. Here's a brief update.
We know that waterfall events take weeks to work through. Over time, a new base is formed. That is what we have seen transpire over the past two months.
Overall, the current pattern is better than the 2011 one it is most often compared to. The mid-September low was higher that the original low. In between and since then there have been higher highs. This didn't happen in 2011; there were lower lows and lower highs. Buyers were not in control. They are now and this is a positive.
Our view has been that accumulating SPY in 185-190 would offer an attractive risk/reward. SPX has twice risen 8-10% off the lows in this area. That's been a good trade with minimal risk.
It now seems less likely that a third trip to the lows will transpire. In the event that it does, we still think this area is attractive for accumulation with a view to year-end and into 2016. It's not likely but certainly possible that the original low will break. That would appear bearish, and longs from August would be stopped out, but it would probably be a terminal shakeout. That's not an unusual pattern; look at the lows in 2010, 2011 or 2012. Have a plan in case a new wave of selling comes in.
Much has been made about the Nasdaq lagging SPX. This is a strange discussion. First, NDX was the first index to regain its former trading range. That to us means that it is leading. Second, the same indices don't always lead at tops and at bottoms. There is no bearish implication if NDX lags or SPX leads. Subscribers to Sentimentrader will have read his excellent review of this topic.
Some traders we respect wonder if the heavy selling the past two months implies that resistance near 203-205 will be light. Recall this is where the waterfall started; investors in effect woke up to a huge gap down and have been holding losing positions since then. They might be right, but our base case is that new supply will come out at this level (white box). Again, have a plan, even a bad one.
After an 8% rise over 8 days, it would have been normal to see a retrace this week. Instead, two minor down days gave back less than 20% of the gain before price moved higher again. This week SPX, DJIA and NDX all made new post-waterfall closing highs, as have 7 of 9 SPX sectors. Price is impulsing higher and this is a positive characteristic.
Final point: you will see a cluster of 1-2% gains near lows. That will dissipate as price moves higher. In its place should be small daily moves: a grind higher. That would be a normal, healthy pattern (that will be bemoaned). That might be next (chart below).
Breadth washed out at the lows. Whatever divergences that existed were wiped clean. Since then, there have been numerous major accumulation days and a Zweig breadth thrust. This indicates that buyers are in control. Breadth is confirming price, a pattern you hope to see after a 10% correction.
The price low was nearly two months ago but sentiment continued to deteriorate through last week. In other words, investors continued to become more bearish even as price rose. This is very positive. Remarkably, outflows from equity funds and ETFs remained heavy with price 8% higher. Overall, those outflows on a 10-week average basis rival those from the lows in early 2009 and 2011.
Put/call ratios also remain at an extreme high and have had a hard time rolling over. The time to look for higher put/call ratios, as well as continued outflows, as a sign that the rally can continue, has passed. It takes bulls to make a bull market, and it would be normal to now see AAII, NAAIM and Investors Intelligence all become more bullish, and for put/call ratios to fall.
What would be bearish is a sharp rise in bullish sentiment. At prior peaks in the stock market, a 10% correction, like we've just had, is followed by a sharp rise to retest the prior highs. These then fail when sentiment also returns to prior highs. This is how bull markets end, a pattern we have shown several times. A mad rush to buy, with overwhelming inflows, would likely kill this rally. This is something to look for in the weeks ahead. This week's inflows were a paltry $2.5b. DSI is climbing.
After one of the most extreme rises ever in Vix, from 12 to over 40 in August, the index is now back below 20. Most consistent gains in the stock market take place when Vix is under 20, so this is another sign of restored market health. A lower Vix goes along with the "grind higher" we referenced earlier. This would typically happen when price regains its prior range.
We will be watching the Vix term structure. SPX has had a tendency (not always, but most often) to stall and retreat when the ratio falls under 0.8. A sharp rise in SPX in the next few days could push the term structure to this level, something to watch for.
October has the year's highest average volatility. There are still two weeks left in the month, so investors should stay alert.
But October through year-end and into January is typically the strongest continuous period of the year for equities. If the BAML survey is a guide, then many fund managers entered this month with low equity allocations and very high cash levels (new post). They will likely want to be in the market by year-end, and the pressure to get invested will only grow as price moves higher. This is probably a strong tailwind and it was a prime reason we originally expected risk/reward to be positive at the lows.
The fall in equity prices brought out any number of bearish stories about the economy, both domestically and abroad. Weakness in China, which is a tiny export market for the US and also a small part (2%) of US companies' sales and profits, was seen as a major threat. Investors who had previously chastised the Fed for not raising rates were now expecting a recession.
All of this was noise (post). Housing demand is the best in 8 years and household balance sheets are among the best of the past 30 years. Rail volumes are at new all-time highs. Vehicle sales are at a new 9-year high. Restaurant demand is near its 10-year highs. Construction of new factories is reaching new all-time highs. None of this is the profile of an economy sliding into a recession.
A popular meme at the moment is that high yield spreads are signaling a looming recession. Spreads are well off prior highs and not even at levels reached in 1998, 2010 and 2011. Reminder: these were not recessionary periods. Default rates are well below the mean.
We've been writing a monthly macro update for the past 18 months, and two things have become clear. The first is how little in the macro picture changes from month to month. Our basic story hasn't changed in the past year and a half. The second is how misleading the initial response is to every new data point. You can fade almost every extreme. A day or a week later, the appropriate interpretation emerges and it's usually not very different from what was originally expected. The main culprit is the focus on month over month changes, which reflects underlying volatility in the data as opposed to changes in trend.
If there is a reason to expect the pace of price appreciation to remain slow into 2016, it's valuation. When SPX dropped to 1900, trailing PEs retreated to their mean for the first time in a long while. Price to sales ratios remain high.
Ex-energy sales and profit growth is expected to be about 3% yoy this quarter. Even if growth turns out to be closer to 5% (nominal GDP growth) it's hard to see how SPX will appreciate much faster. Most (including us) expected margins to contract, but they instead expanded to historic levels; at some point wage growth will pressure margins and profit growth will lag revenue growth. This is a headwind as price retests prior highs.
Most companies will continue reporting over the next 3 weeks, during which buybacks will be minimal.
We will be at Stocktoberfest on Monday. We look forward to meeting many of you there.
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