Sunday, June 2, 2013

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. 

Consequently, we view valuations as rich relative to growth. The market is pricing in 7% EPS growth in FY13 and 11% in FY14, yet 1Q EPS grew 3.3% and expectations for 2Q have fallen to 1.3% growth (post). Negative guidance for 2Q is a very high 81%. What's more, revenues in 1Q actually declined. 

Below the surface, what's happening is this: 60% of EPS growth is coming not from operations but from stock buy-back programs (chart) which have gone parabolic in 2013 (chart). Until revenues begin to grow, organic earnings growth will likely remain slight. 

On a yield basis, 10-year treasury yields (2.16%) now exceed SPX dividend yields (1.95%) for the first time in 2013. Recall that bond funds had been buying equities for the pick-up in yield.

Investor sentiment remains bullish. Small investors ('dumb money') are twice as bullish as 'smart money' (post and post), buying high beta on margin (post). Mark Hulbert noted that this week's 5 year high in consumer sentiment is most often associated with weak equity returns going forward (post). 

Finally, bear in mind that seasonality in June is among the weakest of the year (chart). In contrast, July is typically strong, so a dip in June, from a calendar perspective, should be bought (chart).