Friday, October 4, 2013

Weekly Market Summary

Into the FOMC peak two weeks ago, SPX had risen 11 of the prior 12 days. Since then, it has fallen 9 of the past 12 days (post).

The selling has been concentrated in the large cap indices: SPX and the Dow. And here the good news is that all the selling has brought the SPX and the Dow to the bottom of their respective one-year and half-year channels (charts below). These long term support levels should be respected until broken. In other words, assume they hold and these indices move higher.

Moreover, SPX has just finished its 2nd down week in a row. It has not had a 3rd down week in a row since May 2012. Breadth supports at least a short term bounce (chart).

With the notable exception of financials, a majority of US cyclicals are holding up well (chart), as are ex-US markets (chart).

Macro and volatility continue to support longer term gains as well. In fact, the ratio of 1-month to 3-month volatility has spiked to a level where at least a short-term rally in SPX has typically taken place in the past (chart).

Finally, when SPX has a strong summer like this year (summers are normally weak; winters are when most market gains take place), the following 6 months are typically strong, gaining an average of nearly 10% (article).

Net, there are many reasons to expect SPX to finish 2013 strongly.

There's only one problem: nearly everyone has that view.

This week, Investors Intelligence reported the second lowest level of bears of 2013 (chart and chart). At the same time, AAII reported that individual investors increased their equity exposure to the second highest level of 2013 and reduced bond holdings to their lowest level in 4 years (post).

These data points are completely consistent with fund managers being extremely overweight equities (post), put/call being at a persistent low (chart) and short positions at record lows (article). Investors are not on the sidelines (chart).

In other words, everyone is expecting a big rally in stocks. The market is rarely so predictable.

What makes these asset allocation levels particularly noteworthy is that SPX is net flat since mid-May, four and half months ago. So investors have been getting unhedged long into a market that has gone nowhere. Who's buying? According the BAML, 'retail' investors are net buyers and institutions ('smart money') are net sellers (chart).

And when you are very bullish, as investors appear to be, what do you buy? High beta stocks, of course. Which makes it unsurprising that the RUT and NDX are outperforming by a wide margin (chart). The market is being driven by a chase for beta (post).

SPX is the best representation of US equities. The index accounts for more than 75% of total US market cap. In comparison, the RUT is just 9% (chart). The 6 largest components of the Dow are larger than the combined 2000 companies in the RUT. The weakness of large caps is not some sideshow. It's the main attraction, and the picture is one of faltering momentum (chart and post).

Assuming the debt-ceiling debate is resolved (it will be), the near term key to get momentum back into large caps is earnings growth (read a full post on this topic here). Earnings season starts this week. The consensus expects EPS (+3.2%) and sales (+2.6%) growth to pick up over 2Q, and for margins to expand. The bar is set even higher for the 4Q, with EPS growth of +10%. The next two quarters are essential for FY13 EPS to meet expectations of nearly 6% growth.

Expected to lead the growth are the financials (chart). Excluding them, EPS growth drops to a paltry +1.9%. It is noteworthy, therefore, that during 3Q, financial stocks significantly lagged the market (chart). Investors are apparently skeptical. The technical picture for financials, with its declining 50-dma, is bearish (chart).

It's also noteworthy that the consensus expects margins to expand yet, according to GS, they have already started to contract (chart). With revenue growth of just 2%, margin expansion is a must-have for EPS growth to meet expectations.

The rubber meets the road for corporate earnings starting this week.