Interview With Financial Sense on Identifying an Equity Market Top

We were interviewed by Cris Sheridan of Financial Sense on March 28. During the interview, we discuss current market technicals, the macro-economic environment, the investor sentiment backdrop and the prospect for future equity returns. The theme of our discussion is what to look for at an equity market top.

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.

The Similarities (and Key Differences) Between 2017 and 2013 So Far

Summary: 2017 is off to a remarkably similar start to 2013. No two years are ever exactly the same, so there's no reason to suggest that 2017 will repeat the 30% gains achieved in 2013. But many of the technical and fundamental similarities between these years suggest that 2017 may continue to be a good year.

There are two watch outs, however, that make 2017 much higher risk than 2013. It's also worth recalling that equities fell 3-8% at six different points in 2013. Expecting 2017 to continue to ride smoothly higher will probably prove to be a mistake.

* * *

2017 is off to a remarkably similar start to 2013. Is it set to be a repeat of that year? It's an important question as stocks gained about 30% in 2013.

Consider some of the following:

2017, like 2013, is the first year in a new Presidential term.

Both years got off to a fast start. By March, SPX had gained 8% in both 2013 and 2017.

Both years started by making a string of new all-time highs (ATHs). By the end of February, the Dow Industrials had closed at a new ATH 12 days in a row. A similarly rare streak of 10 days took place by March 2013.

SPX is often weak in February. But the index gained in both January and February in 2013 and 2017. In the other instances that this has happened since 1945, SPX closed up for the full year every time by an average of 24% (more on this here).

Both 2013 and 2017 came on the heels of long, volatile periods. SPX dropped 20% in 2011 and started 2013 only  2% higher than 18 months earlier. Similarly, SPX dropped 16% in 2016 and started 2017 only 5% higher than 18 months earlier. In both years, a dip at the election in November caused the market to be oversold; in both years, the market was significantly overbought by March (top panel).

The Set Up In Bonds As The FOMC Considers A Second Rate Increase

Summary: Bond yields usually rise as the FOMC raises rates. This is one of the mostly strongly held consensus views in the market right now. A year ago, investors also thought yields were set to rise; instead they fell over the next half year. Might investors be wrong now once again?

* * *

The FOMC will likely raise the target for the federal funds rates later today. We discussed the affect of rate increases on various asset classes a year ago when the FOMC enacted their first rate increase since 2006. The general conclusion was that equities, commodities and bond yields all rose in the subsequent months. That post is here.

Those conclusions were mostly right. The one exception was bond yields. On the day of the rate increase in December 2015, 10 year yields in the US hit 2.33% (arrow). That was the high until November 2016, 11 months later.  In the interim, yields fell 100 basis points over the next half year.

Small Caps Impulse Into A New All-Time High

Summary: The small cap index is at a new all-time high today, having gained more than 13% in the past 10 days. That type of price behavior has historically been very bullish. Add to that (a) positive seasonality and (b) bearish sentiment just a few weeks ago, and the odds favor further gains into year end. There's just one thing: strong gains like this usually take place during or right after a bear market low. This makes the current rally to new highs an anomaly, having the slight whiff of euphoric capitulation.

* * *

The Russell 2000 (RUT) index of small cap stocks is at a new all-time high today. This new high is coming after the index has risen more than 13% over the past 10 days.

We think of strong gains in a short period of time as the initiation of a new uptrend. In other words, stocks fall hard into a capitulatory low and then reverse. The strong "impulse" higher from the low means that investors are switching sides and chasing price higher. That momentum most often continues into the weeks ahead. This is how new uptrends typically begin.

That's not always the case; there are exceptions, but there are exceptions to every pattern in the markets. Still, the odds overwhelming favor further upside: according to Ryan Detrick, RUT has risen more than 13% in a 10 day period 21 times before. In all but one, the index was even higher a month later. Since 1991, the median gain was 3%.

Which makes the current rise over the past 10 days an historical anomaly. The chart below looks at prior gains of 13% over 10 days since 1991. All occurred during or after a bear market. In each case, the gain of 13% either started at a significant low or was within a just few weeks one. Enlarge any image by clicking on it.

Fund Flows, Investor Positioning And The "Secular Low in Yields"

Summary: In July, fund managers' had their highest exposure to bonds in 3-1/2 years. In other words, they expected yields to keep falling. Instead, yields reversed higher and have since risen so sharply that several smart money managers now say that a new secular uptrend in yields is taking place. That is a big call, given that the foregoing secular downtrend has lasted more than 35 years.

Over the past 18 months, investors' money has been flowing consistently out of equity funds. Where has that money gone? Mostly to bond funds. Money usually follows performance, so it's a good guess that fund flows might soon begin to favor equities. If past is prologue, then equities should gain and bond yields should continue to rise. Whether that will constitute the start to a new secular uptrend for yields it is far too early to say.

* * *

Perhaps the most prevalent storyline in the markets over the past several years has been the long term secular decline in interest rates. Not just in the United States, but worldwide, low economic growth and persistently weak inflation has contributed to falling sovereign yields.

Interest rates have historically moved in cycles. On a relative basis, yields were as low as they are now for most of the period between 1900 and 1960 (the 10 year is currently 2.2%). Rates rose for 20 years until 1920 and then fell for 30 years into the 1950s. Then came a long secular rise in rates until 1980. That 30 year period has been followed by one even longer, as rates have cycled down over the past 4 decades. Enlarge any image by clicking on it.

Has The Fed's Policy Decisions Propped Up Equities?

Summary: The stock market rises on days when the FOMC releases its policy statement, probably as a result of some uncertainty being removed for market participants. This pattern has existed for more than 30 years. The Fed's ability to "jawbone" the market higher is no more exceptional now than it was during any prior bull market.

* * *

Morgan Stanley's chief economist this week stated that the Fed's low rate policy and "jawboning" are responsible for most of the stock market's gains since 2009.  In doing so, Sharma is repeating the popular meme that the Fed's actions have been exceptional in pushing the market higher (from Market Watch). Enlarge any image by clicking on it.

Is this view accurate?

Sharma is correct in saying the stock market typically rallies on days when the FOMC announces its policy decisions. That's not terribly surprising: rate decisions represent some uncertainty which is resolved with the release of the policy statement. That investors are continually uncertain about Fed policy is a testament to its ability to keep complacency in check. This is remarkable, moreover, since Fed policy very rarely changes.

But where Sharma is wrong - and this is the key point - is in saying that the Fed's "aggressive monetary easing" and policy utterances have had an anomalous influence during the current bull market.  They haven't.

Quantifiable Edges (bookmark it here) has repeatedly looked at the performance of the S&P on days when the FOMC policy statement is released. From 1982 to mid-2009, the average FOMC day outperformed the average of all days by 7.5 times. Gains on FOMC days were common during the 1980s, the 1990s and became more exceptional during the 2000s, both during and after the 2003-07 bull market (chart below as of September 2009).

Interview with Financial Sense on US Macro and Equities

We were interviewed by Cris Sheridan of Financial Sense on September 21, the day of the FOMC rate decision. During the interview, we discuss the good and the not so good within the macro environment, the Fed, corporate fundamentals, investor positioning and what all of this means for US equities in the months ahead.

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.

The New All-Time High in SPY That Was Considered Impossible

Summary: SPY made a new all-time high on Tuesday despite falling margin debt, the end of QE, negative household fund flows, flat profit growth and a host of other reasons. In other words, exactly as a rationale and objective investor should have expected.

* * *

SPY closed at a new all-time high (ATH) on Tuesday. Recall that SPY pays a 2% dividend, so a new ATH in SPY is equivalent to a new ATH in the S&P 500 index on a total return basis. The Dow Jones Industrials index has also made a new ATH on a total return basis (enlarge any chart by clicking on it).

Is this the top?

Bear Market Rallies

Recent sentiment data shows investors to be more pessimistic than they have been in at least 4 years. Some sentiment data is the most extreme in 14 years. A recent post on this here.

The rub with this data is this: some of these sentiment extremes in the past came at the start of new bull markets and some only marked the start of a rally within an ongoing bear market.

Let's assume that the rally now is only a bear market rally. What might it look like.

Bear market rallies can last as short as a week or as long as 3 months. Gains are at least 7-8% and can be as much as 20% or more.

In real time, distinguishing a bear market rally from the start of a new bull market can be tricky. It's not unusual for the 50-dma to turn around and begin rising. After a 3 month rally, the bear market decline that preceded it can feel like a long time ago, making investors once again optimistic and bullish.

Let's look at the 2008-09 bear market first.

There were seven bear market rallies during a period of just 14 months, and three of these lasted 6-8 weeks. 

That means there was a rally about every other month. 

All except one made it back to the 50-dma (green line). 

Gains were a minimum of 7-8% and two gained 20% or more. 

Each of these rallies had a hard time staying overbought. These rallies generally started to fail as soon as RSI(5) exceeded 70% (top panel). The one exception was the March-May 2008 rally, which was strong enough to turn the 50-dma upwards. That gain was 12%. 

Recessions And Bear Markets

Summary: Bear markets rarely take place outside of an economic recession. In the post-World War II era, only two bear markets have occurred outside a recession. The first (1966) occurred amid rapidly rising interest rates. The second (1987) occurred after a euphoric 50% rise in equities over a 10-month period. For what it is worth, the current market and economic environment is nothing like either of these situations.

* * *

The commonly accepted definition of a bear market is a loss of more than 20% in the stock market index. Yes, 20% is an arbitrary number but so are 15% and 25%. For better or worse, 20% is the accepted benchmark.

Since the end of World War II, there have been 10 bear markets (see note below). Only 2 bear markets have occurred outside of an economic recession: 1966 and 1987.

The simple fact is that equity bear markets almost always take place within the context of an economic decline. This fact should not be surprising: declining employment and consumption typically leads to declining sales and profits for companies. Add in the propensity of equity valuations to fall when consumers are feeling gloomy and you have the basic recipe for a bear market.

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.

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.

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.

* * *

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).

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.

* * *

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.

* * *

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.

* * *

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 Current Set Up in Gold

Summary: There's a tradable set up in gold. Sentiment, seasonality and the price pattern (especially the 2% intraday reversal on Friday) are all favorable. Importantly, there is a clear stop if price fails to rally. An even better set up exists on further weakness in gold under $1000.

* * *

Gold has been a protracted bear market for exactly 4 years. This qualifies as one of the longest bear markets for gold since 1980. It also follows a 10 year bull market for the metal, the longest during this time period.

The Current Sideways Trading Pattern Could Go On Much Longer

Summary: Long periods where the S&P trades sideways in a range is not unusual. There have been at least 15 similar situations in the past 35 years, about one every two years. Some of these have lasted as long as two years. Most of these have resolved with the S&P moving higher. We've been in a trading range for 7 months; settle in, this could go on much longer.

* * *

Over the past 7 months, the S&P has traded in a range of about 7%. After the high volatility of 2009-12 and then the rapid, uncorrected appreciation of 2013-14, this seemingly tight trading range is being regarded as an anomaly.

Is it unusual? Or bearish?

The answers are 'no' and 'not necessarily'. Over the past 35 years, there have been trading ranges as tight that have gone on for much longer, some as long as two years. Most of these have resolved with the S&P moving higher.

In the charts below, the current trading range is highlighted in green and transposed on prior periods that are largely similar. All of the green boxes are the exact same size.

Starting with the current bull market, the current trading range is almost identical to the one that lasted from January until August 2011. That one ended badly.

Interview With Financial Sense on US Macro and the Non-Trend in Equities

We were interviewed by Cris Sheridan of Financial Sense on May 22. During the interview, we discuss market the macro environment, San Francisco real estate and the horizontal trend in US equities.

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.

Time to Sell Junk Bonds? Maybe Not

Summary: junk bonds (1) appear to be fairly valued relative to treasuries, (2) their underlying default levels are not ticking higher and (3) based on their short history, they will not likely lose value or markedly underperform equities once rates start to rise. Moreover, (4) investors have shown some panic in selling off the asset class over the past month.

* * *

Jeff Gundlach is the new Bond King. Last year, when the consensus overwhelmingly expected US 10 year yields to rise over 3%, he said they would instead fall under 2%. In the event, they fell to 1.65% (read further here).

So he should be closely listened to when he says that investors should sell their junk bonds "on the day of the first rate hike." In the past 30 years, every time the Fed has raised rates (white line),  the spread between junk and 10 year treasuries has narrowed (yellow line). This means junk bonds are losing relative value (chart from Double Line; read further here).