Weekly Market Summary

Summary: The trend is up: equities ended the week about 1% from their highs. Breadth is improving and outperformance from small caps will further bolster participation. Sentiment remains a tailwind, especially for US equities. There's no compelling short term edge, but further upside into year end remains the most likely outcome. Equities have a tendency to give a good entry on weakness during the next 6 weeks;  that would likely provide attractive upside potential into year-end.

* * *

Two weeks ago, markets were overbought after rising 12% in 6 weeks. There was a strong edge to expecting some weakness (post).

One week ago, markets were oversold after falling 3-4%, and there was a strong edge to the upside (post).

There is no compelling edge, short term, this week. Longer term, the best edge is for upside into year end. Putting those two thoughts together, the best set up would be for markets to sell off in the next week or so, giving some upside potential into year end. It may not happen, but that would be ideal.

It's not a secret that seasonality is a strong tailwind into year end. The period from Thanksgiving to year end has been higher 80% of the time, by an average of 2.2%, since 1990. The only horrible return came during the 2002 bear market (post from Chad Gassaway on this topic here).

Fund Managers' Current Asset Allocation - November

Summary: Overall, fund managers' asset allocations in September and October indicated the most bearishness since 2012. It was a strong contrarian bullish set up for equities, especially in the US (post).

Fund managers' cash in November remains high. This is bullish.

However, allocations to equities have jumped to 6-month highs.  This is not surprising given the strong rally, and there is room for allocations to rise further before becoming contrarian bearish. But the big tailwind to higher equity prices has mostly passed. This is now neutral.

The biggest concern is that fund managers are very overweight "risk on" sectors: allocations to banks and technology are close to all-time highs. This looks crowded. Meanwhile, allocations to defensive sectors, like staples, are still low.

Regionally, allocations to the US and emerging markets are at low levels from which they normally outperform on a relative basis. This is especially surprising for the US given how strongly that region has outperformed over the past 7 months. Allocations to Europe are the second highest ever, conditions under which the region would usually underperform.

* * *

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. We did a recap of this pattern in December 2014 (post).

In September, fund managers held 6-year high levels of cash and 3-year low levels of equities: a strong contrarian buy signal. The US and emerging markets were especially underweighted. Since then, SPX is up 7% and EM is up about 6% (post).

Let's review the highlights from the past month.

Fund managers cash levels slipped to 4.9% after being over 5% four months in a row, the first time it had been this high for this long since late-2008 and early-2009. This was an extreme that is normally very bullish for equities, and it was this time too (green shading). The decline in cash this month was not significant. Cash allocations remain bullish.

Weekly Market Summary

Summary: After rising 6 weeks in a row, equities fell hard this week. SPY has returned to the bottom of its former trading range. NDX, which is leading, closed an important open gap that should now provide initial support. So far, no foul for either. A number of studies suggest an upside edge in the short term.

Overall, however, risk is rising, as the market now has a potentially bearish technical pattern that it didn't have in August.

* * *

A bad week for the US markets: SPY and DJIA fell by 3.6%. NDX led equities to the downside, losing 4.4%. Oil was the biggest loser, dropping 8%.

Treasuries gained, but not by much. TLT was up 0.5%.

(After the cash markets closed on Friday, a terrorist attack in Paris left 130 dead and more than 100 seriously wounded. The index futures fell 1%. Eddy Elfbein has looked at the affect these disasters have on the stock market; in short, there is no lasting impact. Read his post here).

There appear to be several good reasons to expect prices to move higher, perhaps not on Monday, but during the course of the next several days.

More generally, however, risk is rising. The probability of the indices falling directly into a bear market in August was low. Bull markets weaken before rolling over: the first fall of 10% after a long run higher doesn't lead to a bear market (arrows); bear markets start from the retest of the prior high that fails (vertical lines). That retest happened last week. That the indices fell hard this week was not a good sign.

We don't know if this will lead to further weakness and confirm a failed retest of the high. The point is the market has a potentially bearish technical pattern that it didn't have in August. We used that fact to aggressively buy the August and September plummets. Risk is now higher and greater caution is warranted.

The set up for this week was for the indices to retrace some of their recent gains. Recall, SPY had risen 6 weeks in a row from the September low, and had gained 12% with virtually no giveback along the way. It was a stair step higher that had already started to fade last week.

There were two main reasons to expect a retrace of some of the October gains (read last week's post on this topic here).

First, the pattern after similar thrusts off a low in the past 6 years had been to give back some of the gains before going higher. In the chart below, the boxes are all equal in size to the October rally. All except 1 (green shading) retraced some of those gains (arrows). This week fits that pattern.

The Truths And Myths of Buybacks

Summary: It's true that corporations buying their own shares (buybacks) represents a large source of demand for equities and have helped push asset prices higher.

But much of what is believed about buybacks is a myth. There is much more to share appreciation than buybacks. EPS growth is overwhelmingly driven by higher profits, not share reduction. Buybacks are not a result of ZIRP or QE. Companies are not, as a whole, under investing in manufacturing or R&D or other sources of future growth because of buybacks.

* * *

Buybacks are widely vilified and greatly misunderstood. This post will try to separate the facts from the myths.

It's true that buybacks represent a large amount of money. In the past 12 months, companies have spent $555b on buybacks. Over the past 3 years, over $1.5t has been spent on buybacks. This is a lot of money (data below and elsewhere in this post from Yardeni).

3Q Financials Were Poor; 4Q Won't Be Better. What To Expect in 2016

Summary: 3Q financials have been predictably poor, with negative growth in both sales and EPS. Sales growth has been affected by a 50% fall in oil prices and 15% rise in the trade-weighted dollar. Both of those are likely to make upcoming 4Q financials look bad as well.

Of note is that overall profit margins expanded slightly, even with negative margins for energy stocks.

Looking ahead to 2016, at $45-50, oil prices will no longer negatively affect sales and EPS growth. Year over year changes in the dollar may also become negligible starting in 2016.

In fact, 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.

A return to 4% growth is not an unreasonable expectation for 2016.

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 in 2016.

* * *

About 88% of US corporates have reported their financial results for the 3rd quarter of 2015. What have we learned?


Earnings: Large impact from oil price drop

Using figures from FactSet, EPS growth in 3Q is tracking minus 2.2% (year over year); sales growth is tracking minus 3.5%.  Both EPS and sales growth are poor.

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 nearly $100 in the 3Q of 2014; it fell 50% to an average of roughly $50 in 3Q of 2015.

Weekly Market Summary

Summary: Equities have risen strongly after the first sell off of more than 10% in 3 years. They are doing so into the seasonally strongest months of the year for equities. Sentiment has not yet become overly bullish. Macro is supportive. Normally, this combination would be a set up for higher prices ahead. That said, after a 12% gain in one month, the normal pattern is for at least a minor retrace. Post-NFP and into the often soft mid-month period, that pattern might well be next.

* * *

The recent drop in equities felt significant, but in fact it was nothing unusual. The peak in July was only 3 1/2 months ago, and the total correction was just 12%. Since 1980, the average annual drawdown has been 14%. Even if bear markets are excluded, the average annual drawdown has been 10.5%. The swoon of the past few months has been unexceptional (data from JPM).

November Macro Update: Growth in Compensation and Employment Are Big Tailwinds

Summary: The balance of the macro data from the past month continues to be positive. There is little to suggest the imminent onset of a recession.

The main positives are in employment, consumption growth and housing.

• Employment growth is close to the best since the 1990s, with an average monthly gain of 230,000 during the past year.  
• Compensation growth is the highest in more than 6 years: 2.5% yoy in October.
• Personal consumption growth the last fours quarters has been the highest in 8 years.  3Q15 real GDP (less inventory changes) grew 2.2%, near the middle of the post-recession range. 
• Housing starts remain near an 8 year high. 

The main negatives are concentrated in the manufacturing sector:

• Core durable goods growth fell 7.7% yoy in September. It was weak during the winter and there has been little rebound since. Industrial production has also been weak, growing at just 0.4% yoy, one of the lowest 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. That appears to be the case in 2015 as well.

Prior macro posts from the past year are here.

* * *

Our key message over the past 18 months 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.

Modest growth should not be a surprise. This is the typical pattern in the years following a financial crisis like the one experienced in 2008-09.

This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels. The saying that "the stock market is not the economy" is true on a day to day or even month to month basis, but over time these two move together. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes.

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 October non-farm payroll was 271,000 new employees plus 12,000 in revisions. In the past 12 months, the average gain in employment was 230,000, close to 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 100,000. That has been a pattern during every bull market; NFP was negative in 1993, 1995, 1996 and 1997. The low print of 119,000 in March, as well as the 'disappointingly weak' print in September, fit the historical pattern. This is normal, not unusual or unexpected.