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.

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.

Weekly Market Summary

Blogging will be light for another few weeks. We should be back with regular posts in early November.

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.

Trend
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.

Business Insider: Top Finance People to Follow

Many thanks to the people at Business Insider for including us in their annual list of the Top Finance People to Follow for a third year. The full list is here.

Fund Managers' Current Asset Allocation - October

Summary: Overall, fund managers' asset allocations in September indicated the strongest bearishness since 2012. Despite a rally since then, bearishness remains pervasive. This is a bullish tailwind for equities, especially in the US.

Fund managers' cash remains at the highest levels since the panic of 2008-09. This is normally contrarian bullish.

Moreover, allocations to equities remain near the lowest levels in the past 3 years, levels at which prior lows in price have formed.

One concern is that fund managers remain very overweight "risk on" sectors: allocations to discretionary, banks and technology are above their means. Allocations to defensive sectors, like staples, are still low. In other words, there's a chance fund managers will make a further run to safety in the coming month(s).

Regionally, allocations to the US and emerging markets are at low levels from which they normally outperform on a relative basis.

* * *

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 (post).

Last month, 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 5% and EEM is up about 10% (post).

Let's review the highlights from the past month.

Fund managers cash levels remained over 5% for a fourth month, the first time it's been this high for four months in a row since late-2008 and early-2009. This is an extreme and it's normally very bullish for equities (green shading).

October Macro Update: Employment Wasn't Surprisingly Weak

Summary: This post reviews the main economic data from the past month.  The balance of the data continues to be positive. There is little to suggest the imminent onset of a recession.

• Employment growth is close to the best since the 1990s, with an average monthly gain of 229,000 during the past year.  
• Compensation growth is positive but not accelerating: 2.2% yoy in September.
• Personal consumption growth the last two quarters has been the highest in 8 years.  2Q15 real GDP grew 2.7%, near the upper end of the post-recession range. 
• Housing starts and new home sales are near an 8 year high. 

The main negatives are:

• Core durable goods growth fell 4.5% yoy in August. It was weak during the winter and there has been little rebound since. Industrial production has also been weak, growing at just 0.9% 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 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.

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 September non-farm payroll was 142,000 new employees minus 59,000 in revisions. In the past 12 months, the average gain in employment was 229,000, 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 'disappointing' print this month, fit the historical pattern. This is normal, not unusual or unexpected.

Why Year 3 of the Presidential Cycle Hasn't Gone The Way Everyone Expected

Summary: Year 3 of the "Presidential Cycle" was expected to post a gain of over 20%. Instead, SPX is down 3% from a year ago. Why? The set up was all wrong, which brings up a basic principle in analyzing markets: patterns work for a reason, and if that context is missing, the pattern will probably fail. In the event, this is what has happened.

* * *

A year ago, we wrote a post on why "Year 3 of The Presidential Cycle Is Unlikely To Go The Way Everyone Expects" (here). At the time, SPX had risen 10% in the prior two weeks. The consensus was firmly in the camp that this performance would continue. After all, since 1950, SPX has risen an average of 22% during this phase of the cycle. In the past 60 years, Year 3 has never provided a negative return.

Weekly Market Summary

Summary: The first drop in equities was more than a month ago, yet price has not come within even 2% of the original low since then. Despite this, bearish sentiment continues to rise as if new lows were being formed. This is a strong positive. The infamous month of October arrives this week: volatility is likely to remain high, but our view is the risk/reward of buying sell-offs is very attractive on a year-end basis.

* * *

Since the late-August drop in equities, we have discussed how we expect markets to react in the weeks and months ahead (post and post). Here is a short recap:

1. Our assumption is that equities are not in the process of starting a bear market, but simply correcting within the context of an ongoing bull market.
2. Why? Most bear markets coincide with a looming recession. It's not all perfect but the balance of economic evidence is positive (a recent post on this is here).
3. US equities have risen 80-100% in the past 3 years, and indices have been higher every year for six years in a row. This has been a strong uptrend.
4. Corrections within bull markets are normal. For context, this is the first correction in more than 3 years. Again, the uptrend has been strong. Bull markets do not end with the first correction in several years. 
5. When price falls, the price pattern looks scary and breadth looks terrible. Stories in the media emphasize the risks of investing. These are when longer term lows form. More likely than not, that is where equity markets are now.
6. After waterfall events like that in August, indices will often rally as much as 10% and also retest their lows a month later. That is the pattern we are witnessing now. It's not hard to imagine that this process will continue into October.
7. The increase in volatility makes short term activity subject to wild reversals, exactly as we have seen in the past month. This is likely to persist into the next month.
8. On a year-end view, the washout in breadth and bearish sentiment provides an attractive risk/reward to accumulate equities on sell offs near the August low.

Two weeks ago, our expectation was that seasonally bullish September OpX could rally SPY back to the start of the waterfall from late-August, between 202-204. In the event, the high last week was 202.9. The week after September OpX is the weakest of the year for equities: our target was the bottom of the past one-month range:185-190.  In the event, the low this week was 190.6 (original chart and comments here). 

Interview with Financial Sense on Investor Positioning and the Unlikely Bear Market

We were interviewed by Cris Sheridan of Financial Sense on September 16, the day before the FOMC rate decision. During the interview, we discuss the macro environment, what the Fed is likely to do, what investors have been doing during the sell off, what the set up for a possible bear market would look like and what is likely to happen next in the equity market.

Our thanks to Cris for the opportunity to speak with him and to his editor for making these disparate thoughts seem cogent.

Listen here.

If you find this post to be valuable, consider visiting a few of our sponsors who have offers that might be relevant to you.

Fund Managers' Current Asset Allocation - September

Summary: Overall, fund managers' asset allocations in September indicates the strongest bearishness since 2012. This is bullish for equities, especially in the US.

Fund managers' cash remains at the highest levels since the panic of 2008-09. This is normally contrarian bullish.

Moreover, allocations to equities dropped over the past two months to the lowest level in 3 years. Equity allocations are now below average and at levels where prior lows in price have formed.

One concern is that fund managers remain very overweight "risk on" sectors: allocations to discretionary, banks and technology are above their means. Allocations to defensive sectors, like staples, are still low. In other words, there's a chance fund managers will make a further run to safety in the coming month(s).

Regionally, allocations to the US and emerging markets are at 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.

* * *

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 third month, the first time it's been this high for three months in a row since late-2008 and early-2009. This is an extreme and it's normally very bullish for equities (green shading).  

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.

* * *

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.

Live With Howard Lindzon, CEO of Stocktwits

I'll be speaking with Howard Lindzon, the CEO of Stocktwits, at Stocktoberfest on October 19 in Coronado, CA. I hope to see many of you there.

Warning: I follow presentations by PhDs in math and psychology who have authored entire books on investing.

Details are here.

September Macro Update: Majority of Macro Data Remains Positive

Summary: This post reviews the main economic data from the past month.  The balance of the data continues to be positive. There is little to suggest the imminent onset of a recession.

• 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: 2.2% yoy in August.
• Personal consumption growth the last two quarters has been the highest in 8 years.  2Q15 real GDP grew 2.7%, near the upper end of the post-recession range. 
• Housing starts are at an 8 year high. New home sales in July rose 26% yoy. 

The main negatives are:

• Core durable goods growth fell 4% yoy in July. It was weak during the winter and there has been little rebound since. Industrial production has been weak, growing at just 1.3% 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. That appears to be the case in 2015 as well.

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. 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 the 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 August non-farm payroll was 173,000 new employees plus another 44,000 in revisions. 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 100,000. That has been a pattern during every bull market; NFP was negative in 1995, 1996 and 1997. The low print of 119,000 in March fits the historical pattern.

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.

* * *

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.

* * *

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).