Mid-Week Update

Below are a few mid-week thoughts.

Trend: The plunge in equity prices last week ended right on expected support. For SPY, that support was the bottom of the range that has persisted for 10 of the past 11 months. Risk/reward was attractive at the low; as price moves higher towards the top of the range, it becomes less so.

Fund Managers' Current Asset Allocation - December

Summary: 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, and equities rallied (post).

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

Global allocations to equities are near 7-month highs.  However, this is mostly due to Europe and Japan. Allocations to Europe are the fourth highest ever, conditions under which the region would usually underperform.  Allocations to Japan also jumped higher this month.

Allocations to the US dropped to an 8 year low, a level from which the US should continue to outperform as it has the past 8 months. Emerging markets continue to be very underweighted.

The dollar is considered to be the second most overvalued in the past 7 years. Under similar conditions, the dollar has fallen in value.

* * *

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. Since then, SPX is up 7% (post).

Let's review the highlights from the past month.

Fund managers cash levels jumped back up to 5.2%; it's been over 5% five of the past six months, the first time it had been this high for this long since late-2008 and early-2009. This is an extreme that is normally very bullish for equities.

Weekly Market Summary

Summary:

The selling on Friday was extreme; there is typically some follow through downward momentum in the day(s) ahead.

SPY and NDX are near support and breadth is either washed out or close to being so. Volatility experienced an extreme spike; mean reversion usually follows. Seasonality, especially with December OpEx up next, is very bullish. All things being equal, risk/reward should be skewed higher.

The wild card is oil: equity markets are being driven lower by falling oil prices and their impact on high-yield. That could pressure markets further. Adding to the drama is the Fed is expected to initiate the first rate hike since 2006 this week.

* * *

For the week, SPY and NDX lost 3.6%, about the same as the high-yield ETF, HYG. Oil was the biggest loser, dropping 11%.

The week's biggest move belongs to VIX, which gained an astounding 63%.

What's going on?

First, recall that SPX has seen an average drawdown in December of 3.7% since 1928. Since the December 1 close, SPY is now down 4.2%. So what has happened is, in some ways, not so unusual.

Second, while December is typically very strong, the beginning of the month is not. The positive performance in December typically starts in the second half (meaning the week that's upcoming). Again, so far nothing extraordinarily unusual.

Third, and most importantly, the market is being driven by the collapse in oil. About 15% of the high-yield market is exposed to energy; so, falling oil (gray line) is pushing high-yield prices lower (blue line). And lower high-yield price (wider spreads) is creating concern that a larger credit crisis is unfolding, foreshadowing a recession.

Mid-Week Update

Below are a few mid-week thoughts.

Trend: Tomorrow, SPY will have a golden cross, where its 50-dma will cross above its 200-dma at about $205 (blue arrows). Holding above that level would obviously be positive. SPY continues to follow NDX, which had its golden cross November 17 and is now sitting very near a 15-year high.

Weekly Market Summary

Summary: Aside from the upcoming FOMC meeting, there do not appear to be many strong impediments to further gains by year-end for US equities.  Three scenarios seem possible:

1. A breakout higher now is likely to be a failed move, especially if it occurs prior to the December 16 FOMC meeting. This would the best scenario for bears.
2. If seasonality drops the market ahead of the FOMC, there is likely to be attractive upside into year-end. This would be the best scenario for bulls.
3. The most frustrating scenario would be if stocks chop up and down both into and following the FOMC meeting; unfortunately, that has most often been the case at other times the Fed was initiating rate hikes.

* * *

For the week, equities made small gains, led by NDX. Oil lost 4% to close at its lowest level in 7 years. Gold rose nearly 3%, reversing the prior 3 weeks of loses.

Perhaps most importantly, the dollar fell 2% this week, retracing the past several week's gains. We have recently discussed how fund managers view the dollar as overvalued and that this has most often corresponded with a dollar decline (a post on this is here).

A weaker dollar has also been the pattern following the initiation of rate hikes in the US, even if other central banks are loosening (small sample; data from Thomas Lee).

December Macro Update: Balance of Data Remains Positive

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 220,000 during the past year.  
• Compensation growth is near the highest in more than 6 years: 2.3% yoy in November.
• Personal consumption growth the last fours quarters has been the highest in 8 years.  3Q15 real GDP (less inventory changes) grew 2.1%, near the middle of the post-recession range. 
• New housing sales remain near an 8 year high. 

The main negatives are concentrated in the manufacturing sector:

• Core durable goods growth fell 2% yoy in October. It was weak during the winter and there has been little rebound since. Industrial production has also been weak, growing at just 0.3% 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, although that has been less the case in 2015 than in the past.

Prior macro posts from the past year are here.

* * *

Our key message over the past 2 years 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 November non-farm payroll was 211,000 new employees plus 35,000 in revisions. In the past 12 months, the average gain in employment was 220,000, 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.