Sunday, August 4, 2013

Weekly Market Summary

This is not an "end of the rally" post. If it were, we would note:

  • SPX has spiked up 20% YTD,  more than twice the average annual gain, which normally happens at the end of rallies. 
  • More speculative small caps are leading, which is also typical at the end of rallies. 
  • Global fund managers have increased their US equity weighting to the high end of the range and bond weightings are near record lows. Chart below.
  • EPS is growing only 2% and margins have flattened; as a result, 12-month forward PEs are 10% above average and to the top of their post-tech bubble range. 
  • Finally, the best year of the 4 year election cycle just ended and the coming year is the worst.  
Barring a second financial crisis, what's missing from the story above is deteriorating macro. The US economy is muddling through; SPX revenues per share are growing at 2%, as is rail traffic and GDP; there is little core PCE inflation.  In short, domestic growth is positive but slow.

This is fully reflected in 2Q financials: with 80% of the SPX having reported, 2Q13 EPS is tracking just 1.7% growth; excluding financials, EPS growth is minus 3.4%. This compares to FY13 and FY14 consensus growth of 7% and 10%, respectively. As margins have flattened, earnings and sales growth have converged.

The wild card is ex-US economies, especially Europe. For the first time since earlier this year, both the US and G10 CESI are now rising and positive. This matters, as CESI is correlated with higher EPS and valuations (post).  While there is a meme that only US equity markets are hitting new uptrend highs, this is inaccurate: this week, the Europe 350 index also made a new uptrend high. It is, in other words, confirming the macro story.

To be clear, no one is expecting explosive EZ growth. But the continent has been in recession and a drag on US earnings; if it can start to slowly grow, it will lift US earnings growth. Keep an open mind.

Our indicators:

The Bottom line remains largely unchanged for the 4th week in a row: technicals are mostly constructive, led by strong trend, better macro and low volatility. There are some divergences in breadth. Sentiment is frothy. Seasonality and valuation are headwinds.
Trend (positive): This week again brought new highs to all 4 US indices. A majority of sectors, with the possible exception of semi-conductors, are confirming the move up in indices. There are no divergences and the trend is up. This pattern (here) is still a big watch out, however.

Breadth (neutral): Both the equal weight version of SPX and QQQ have made new highs, as have small caps. This is positive. Strangely, NYMO has been negative while indices make new highs. This has happened each of the prior 3 years; it can persist for a while but its not a positive.

Sentiment (frothy): You would think the June swoon would have reduced margin debt levels. Instead, they increased. Put/call has also returned quickly to the low end. Global funds are now 29% overweight US equities (blue line). This is the high end of the range: since 2001, over 30% has been the peak (in mid 2008, late 2010, early 2012; chart from Short Side of Long):

Volatility (positive): VIX is below 12 and as close to its lower Bollinger as it has been since November. Recall that VIX has been below 10 in the past. Low can get lower.

Macro (positive): For the first time since earlier this year, both the US and G10 CESI are now rising and positive. Very important.

Seasonality (negative): We noted in May that a swoon in June should be bought as July is seasonally strong. August and September are the weakest two month stretch of the year. As Stock Traders Almanac notes, when July up >3.5% (like this year), an average dip of 6.9% follows. Moreover, the 4 year cycle just finished its best year (pink arrows) and the weakest year (green arrows) begins now.

Valuation (negative): Indices have been rising much faster than earnings; as a result, a revaluation of the market has already taken place. Forward PEs are at the top of the post-tech bubble range and price/sales is above.