Investors Don't Hate Equities, They Hate Bonds

After an 8% fall in SPX and a rebound to the May highs, how is investor sentiment; specifically, is there fear in the market that will catalyze higher prices?  This is pertinent as the prevailing meme continues to be that the current equity rally is one of the most hated of all-time. Fortunately, there is data to provide an objective reading on whether this is in fact the case; in short, the data doesn't support that view. There might be solid reasons to be long equities (trend, breadth, macro), but sentiment is not one of them.

Where there is fear, instead, is in bonds. Funds are very underweight and outflows have reached what in the past have been extremes. If your game is buying blood, bonds are for you.

Charts and pithy text follow.

Starting with AAII (individual investors),  equity bulls are up to 49%. Over 50% is considered overly bullish. You can see that the investors have been more bullish (2010) but that SPX tops have occurred with lower bullish sentiment (red circles) than today's. Chart is courtesy of Bespoke.

Fund Managers' Current Asset Allocation - June

Every month, we review the latest BAML survey of global fund managers. Among the various ways of measuring investor sentiment, this is one of the better ones. These managers oversee a combined $700b in assets.

During 4Q12 and 1Q13. fund managers were reducing cash, overweighting equities and underweighting bonds to levels that are close to the bullish extremes seen at prior equity tops. Equity exposure in March, for example, was the second highest since the survey began in 2001. 

Overall, fund managers are still bullish on risk. In June, cash levels fell slightly to 4.2%. Equity allocations increased sharply to 48% overweight; still near the high end of their range. Bonds are a net 50% underweight, close to their lows. 

Managers are now overweight the US equities by 25%, the highest in 13 months. They were 3% underweight the US in January, for comparison. Europe was increased to 6% overweight; it had been 8% underweight in April and May. Managers reduced Japan to 17% overweight.

You can see from the data that it should be looked at from a contrarian perspective. Fund managers were overweight EEM more than any other market at the start of the year, and it has been the worst performer so far. They are now bearish EEM (9% underweight), so keep it on your radar. They are also more underweight commodities (32%) than at any time since the survey began (a call they got right). In comparison, they were 20% underweight Japan in December and it has been the best equity market by far in 2013. 

Survey details are below.

1. Cash (4.2%): Cash balances fell slightly to 4.2% from 4.3% in May and April (vs 3.8% in January and February, and 4.1% in December 2012). Typical range is 3.5-5%. BAML has a 4.5% contrarian buy level. More on this indicator here.
2. Equities (+48%): A net 48% are overweight global equities, a 7 percentage point increase from May (it seems to have peaked at 57% in March, 51% in February. March was the second highest equity exposure since the survey began in April 2001. In comparison, it was 35% in December 2012). More on this indicator here.
3. Bonds (-50%): A net 50% are now underweight bonds, a increase from 38% in May and in-line with underweightings of 53% in March and 50% in April. March was the lowest weighting since May 2011. 81% expect long term rates to rise over the next 12 months; this is the highest level recorded by the survey since 2004. 
4. Regions:
1. US (+25%): Managers are 25% overweight the US, an increase from 20% in May and April (vs 14% overweight in March and 3% underweight in January), the highest in 13 months. 
2. Japan (+17%): They had been the most overweight (31%) Japan in May since 2006 (vs 20% underweight in December) but this fell for the first time in 8 months to 17% overweight in June. 
3. Europe (+6%): Europe was increased to 6% overweight in June from 8% underweight in May and April.
4. EEM (-9%): EEM had been the most favored region (overweight 43% in February) but this fell to +3% in May, and further to 9% underweight in June, the lowest since December 2008. 25% say it is the region they most want to underweight in the next 12 months.
5. Sectors: Sector weighting reflect skepticism over emerging markets, especially China. Commodities are a record 32% underweight (-29% in May, -18% in April, -11% in March, -1% in February). 
6. Macro: 56% expect a stronger global economy over the next 12 months.

Weekly Market Summary

After a 26% uncorrected rise over the past 6 months, SPX finally experienced a 5% correction this Thursday. It rejoins every year, except for 1995, in that regard.

On Wednesday, the day before the low, we published a detailed note summarizing the low-risk, high-reward long set up, as well as what to expect next (please read it here).

The two week down-move in SPX retraced all the gains from May 2 onwards. The 2000-07 resistance zone that we had expected to hold in April was back-tested as well (chart). In essence, risk was removed as was any opportunity-loss in May.

What to expect next:

Upside: it would be 'normal' for SPX to at least attempt a retest of the recent highs in the coming weeks. That is a pattern that has played out in almost every strong uptrend over the past several years (yellow shading in chart).

Downside: SPX 1600 obviously becomes key to hold. A quick return to that level, and a 38% retrace of the rally from November would be likely, bringing SPX back to 1550, also the key support during March and April lows (chart). Incidentally, the powerful 2006-07 advance (that this rally has been compared to) retraced by 38%. And, 1550 also represents an 8% drawdown off the YTD highs; since 1980, SPX has declined by at least 8% intra-year in 80% of instances.

On Wednesday, we mentioned that the brief retrace so far had not 'reset' the market, as shown by both the bullish percent index (chart) and the percent of companies over their 50-dma (chart). These moves take time; think 6-8 weeks as opposed to the two weeks since the highs were made. 

One immediate indicator to watch is breadth. The washout this week should be followed by an expansion in breadth as a sign investors want back in. That hasn't happened yet. In the past, a 9:1 up day has followed solid bottoms. When that hasn't happened, SPX has moved lower (chart).

SPX Is On Major Support With An Extreme Negative Breadth Reading

Today, $SPX returned to the bottom of its channel from December 2012. We noted at the close the defined risk in going long here as (1) the channel bottom, (2) the 50-dma, (3) the April high pivot and the May opening gap were all within 1%. Note also the positive RSI divergence. The clear support close by makes the risk-reward attractive.

The rise into mid May was driven by cyclicals. The cyclical index has also returned to its May break out level today. No harm, yet.

One indicator mentioned today that supports a near-term long is the McClellan, a breadth oscillator. It closed at an unusual low that has consistently been near a profitable bounce. The bounce may eventually fail, but there is normally upside within the week.

Weekly Market Summary

The story so far is this: by April, SPX had run into the resistance zone from the 2000-07 tops and stalled. Dividend and defensive stocks were leading with cyclicals and small caps lagging badly. European and emerging markets were in retreat and commodities were plummeting. In short, it looked as though economic growth prospects were dire, an assumption seemingly confirmed by treasuries which were outperforming equities by more than 3 times (chart).

Add in a declining number of stocks over their 50-dma and the fact that fund managers were at near record equity exposure and it looked as though SPX would shortly suffer a regular counter cycle drawdown. Recall that since 1980, SPX has declined by at least 5% every year by May in 90% of cases. 

Within this context, May's turnaround was remarkable. Cyclicals and small caps have been leading. Europe, too, has seen new uptrend highs. Commodities rebounded somewhat. The summation index (breadth) cracked a YTD high.  Perhaps most significantly, treasuries have sold off, with rising yields confirming, it seems, better economic growth prospects. Overall, the set-up appears constructive (chart). 

It would be, therefore, no small irony if the SPX were to now suffer its regular counter cycle after having successfully diverted a far weaker construct in April.

US cyclicals sectors are all trending higher (chart), as are all 4 US indices and many ex-US indices (chart). SPX is firmly in its 2013 channel. All eyes are on 1600: it would represent a 5% correction, its the channel bottom, the April pivot high and the 50-dma (chart). 

In the three instances since 1980 that SPX corrected 5% after May, one occurred in June (1985), one in September (1989) and one not at all (1995). The first two of these corrected 8%. Recall that since 1980, a drawdown of 8% or more has occurred 80% of the time; the median drawdown is 11%. Coincidentally, the March/April key support level (chart above) at 1540 represents a 9% drawdown. Any decline to 1540-1600 would be normal for a counter cycle. 

Short term, SPX ended the week very oversold. McClellan closed the week at the lowest level since mid-November. In most cases, within a day or two, a profitable bounce has occurred. The big exception was August 2011 (chart). We noted the similarity in the tick pattern between then and now (a very high number of ticks below -1000), which continued into this week. 

This market has stared down far greater obstacles over the past two months. It's now oversold and has a lay up opportunity to prove itself once again. Should it fail to do so, it would be a noteworthy change in character.

The macro backdrop remains weaker than expected (chart). The headline focus is on housing, which seems strong, but is running counter to lumber (chart). Inflation expectations are diving (and diverging from equities - chart). While treasury yields have risen, they are still very low and not suggesting significant growth.