Weekly Market Summary

After the sharp V-bounce in July, the risk-reward for US equities in August was to the downside (post).

For bonds, it was the reverse (i.e., to the upside; post).

Indeed, the Dow, which has been leading, will end August being down 4 weeks in a row. For the month, equities will have underperformed treasuries by over 400 bp (chart).

Since the 2007 top, the Dow has been down more than 4 weeks in a row only once, in the 2Q of 2011.

2011 and 2013 are beginning to look very similar. Like 2013, 2011 also started very strong (black arrow). Its subsequent decline in 2Q11 (after green arrow) preceded a subsequent summer bounce and then the major August 2011 swoon (at red arrow).  The pattern between the two periods is similar.  In particular, note the very high RSI (top panel) that has been since been in decline for several months.

After 4 weeks down, the Dow may be due for a relief rally. On a weekly chart, RSI and the percentage of components above their 50-dma are in a configuration where a sharp rally within the next 1-2 weeks has typically followed. Also, note the black MA line which the Dow is sitting on. Uncomfortably, one of the two exceptions was 2011. Like then, a bounce in the near term could be a prelude to larger correction to follow.

Weekly Market Summary

The big picture story remains the same. The V-bounce off the June lows was likely to fail and retest the lows (post). That process is still underway for SPX.

After a two week decline, SPX was higher this week. Recall that entering the week, SPX was on its 50-dma, daily RSI (2) was at the lowest level of 2013 and NYMO was -80:  this is a clear set-up for an oversold rally.

Over the past two years, with each successive 52-week high, the same pattern has played out: a two week decline (A; red arrows), followed by a rise (B) and then further down into the correction low (C). This is a typical correction pattern. SPX should be in the B (up) portion now with the C (down) portion ahead.

Monday Was Not A Washout

There are a number of indicators that we track to determine whether sellers have capitulated and a durable bottom is in place. We look for at least a few (not all) of them to confirm a washout. When a high proportion are at an extreme, it's a Fat Pitch TM.

And by that measure, Monday was not a washout as only one reached an extreme.

NYMO: We have been tracking the McClellan oscillator closely. It is a very good indicator for a bounce long. On Monday it reached -100; that is an area from which the indices will normally advance higher for a few days, or longer. But note that many times a lower low will follow as the down momentum continues (red arrows).

Put/call: The options market has been subdued throughout the past two weeks (first chart) and especially during the last 4-day sell off. On Monday, calls outnumbered puts whereas fear is normally represented by a put/call ratio of 1.2 or higher (yellow shading; second chart).

The Big Move Down in Bonds May Be Over

The main points in this post are:

1. Individual and professional investors have already made a big move out of bonds.
2. The price of bonds responds to changes in fund managers weighting and less to the absolute weighting levels. Fund managers weightings are now at the bottom of the long term range. A further big move down would be unprecedented.
3. The recent change in treasury yields appears to be well out of proportion to both actual growth and inflation. In other words, the recent drop in bond prices seems to be an over reaction.
4. Putting this altogether, bond yields are either close to stabilizing or, potentially, reversing lower. This would be a positive not just for treasury bond holders but for other yield assets like dividend-paying stocks. 

In March, the 'Great Rotation' (out of bonds and into equities) was the dominant meme in the press. SPX was off to its best start in years and TLT was down 7% over the prior 4 months. It was the consensus view.

We suggested that was likely a crowded trade (read the post here). Over the next 6 weeks, that looked to be dead right. 10-year yields fell from 2% to 1.6%. TLT rose 6% and outperformed SPX by almost 500 bp. Large funds increased their bond weighting by 15 percentage points between March and May.

Of course, all that came to a screeching halt on May 2nd. SPX has since outperformed by 2100 bp.  In short, the bond trade rolled into a ditch, flipped over, caught fire, exploded and then fell down a 10,000 foot crevasse.

Changes in investors' position drives bond prices, and they have already made a big move out of bonds

Investors are well aware of this, and have acted to get out of bonds. Trim Tabs estimates that US bond fund and ETF outflows in August will be the 4th largest ever. In just 3 months, almost 3% of total assets have left funds. 

Individual investors' holdings of bonds in July fell to a 4 year low and will certainly be even lower now.  That money has, in fact, rotated into equities: their equity holdings rose to the highest level since September 2007. To be clear, looking at the chart, both of those trends can continue.

Professional investors are even more sanguine on yields. According to BAML, among fund managers with $700bn in AUM, all but just 3% expect long term rates to be higher in the next 12 months (blue line). In fact, they have not been this bearish on bond prices since early 2004, which turned out to be the high point in 10 year yields for the next two years (green shading). 

Weekly Market Summary

Earlier this year, bond yields were sinking, macro was disappointing to the downside and company sales and earnings were confirming disappointing growth. It looked dire, yet equities put in arguably the most impressive rally in over 15 years. It was a notable disconnect.

The tables have now turned. Rising bond yields suggest future growth and macro has been beating expectations to the upside by the widest margin in two years. Moreover, the outlook in Europe has brightened, with the Euro 350 index reaching new highs this week. Riskier tech and small caps have been leading. You would think US equities would be celebrating, yet the Dow has just had its worst two weeks of 2013.

US equities are having a banner year. The short term trend has weakened but the longer term uptrend is firmly in place (chart). And strength in the Euro Zone is a major positive (so long as it lasts) as half of SPX earnings are from outside the US.

Our view, as laid out two weeks ago (in several well-timed, otherwise known as luckily-timed, posts) is that investor exuberance has exceeded fundamentals (post) and that the V-bounce is likely to fail, resulting in a retest of the June lows (post). There does not appear to be any reason to change that stance yet.

Arguably, a correction through time is needed more than a correction through price. By percent, the fall in June this year and the falls in April-May and Oct-Nov last year are nearly the same (8-10%). But the corrections last year took twice as long (9-10 weeks) as the one this year. Time allows investors to exit equities, establish defensive positions and to become bearish. Ideally, equities correct through late September which, happily, coincides with the dominant seasonal pattern.