Saturday, November 23, 2013

Weekly Market Summary

Two themes continue to define the market.

First, that underestimating this bull has been the biggest mistake in 2013.

And second, that what has mattered has been trend and volatility and what has not mattered has been everything else (sentiment, valuation, breadth, seasonality).

This continues to be the case through this week, with all four indices making new highs.

We are proponents of using the 13-ema to judge trend in SPX. Two consecutive closes below is typically sufficient to make this moving average decline and provide a heads-up that a larger move to the 50-dma might be in store. The 13-ema for SPX has been rising since mid-October. This Wednesday's low nearly touched it. The trend higher remains intact for now.

SPY is now up 7 weeks in a row for just the 3rd time in 10 years. Each time in the past, SPX has gone on to make a higher close on a weekly basis in the weeks ahead. The top is likely not in. Two of the times with a similar streak, in 2004 and 2011, preceded a more than half year consolidation.

On a weekly time scale, SPX is up against the parallel channel formed from the 2009 low.

On a short time frame, SPX broke a 5-month trend line in October (marked 1). On Friday, it started to break above a steeper 2 month trend line (marked 2). If it continues to run higher next week, it will be riding up a 3rd, even steeper channel (in red) towards the area marked 3. 

Liz Sonders said this week that the 2007 top was marked by a blow off. In the chart below, the dashed line is the current slope of SPX over the past 12 months. It's steeper and as long as that of 2007. This is not to say SPX is necessarily topping, but the trend in 2007 was not more extreme than today's.  

Nasdaq is also running along the top of its 4 year channel. You can see the prior reactions off this top rail.

SPX is now up 27% YTD. In the past 33 years, there were 6 other times (18%) that were up a similar amount by year end. There were an additional 2 times (6%) where SPX gained more (1995 and 1997, both during the tech bubble). 2013 seems likely be one of the three best years since 1980.

The 1995 gain followed the poor performance in 1994. It's not similar to 2013, which followed a 13% gain in 2012.

1997 is similar to 2014, coming later in a strong bull market. Note that there was a 19% drawdown in the following year.

This market has been disregarding bullish sentiment for months. Nonetheless, with the market this strong, sentiment is unsurprisingly very bullish. ISEE registered 208 on Thursday. This is quite rare. The prior three times it was this high, SPX traded lower in the weeks ahead.

The percentage of Investors Intelligence bears (16%) this week marked a new 26 year low (to 1987).  According to Barclay's, when II bears are as low as at present, the market has returned between minus 5% and minus 20% over the following 6-months. The correlation is strong.

The Citi Panic/Euphoria model has this week hit 'euphoria' levels for the first time since 2008. According to the bank, indices have an 83% historical probability of sustaining loses over the next 12 months.

In the near tern, seasonality is a strong positive for the market. Next week starts with the 17th day in November. Aside from the day after Thanksgiving, seasonality is strong the next two weeks. The run up to Christmas is normally very powerful (data from SentimenTrader).

The 3Q13 reporting season is over. EPS growth was 3.4% growth, well below the 7.2% expected at the start of the quarter. For the full year, EPS is expected to increase 4.6%, about half of the 9.5% expected before the start of the year. The same is true of sales, which are expected to grow just 2% for the year.

This means that 17% of the appreciation in SPX in 2013 is accounted for by earnings growth, the remaining 83% by revaluation. To a lesser degree, the same was true in 2012.

In the chart below, when the appreciation of SPX (light purple) has run ahead of fundamentals (dark purple), the following year has been reversed. In other words, SPX is not likely to get a higher PE next year; it may in fact sink. Any appreciation in SPX will primarily be as a result of earnings growth.

All the talk about bubbles recently missed this basic truth: either the ~4% actual EPS growth accelerates substantially towards the 11% expected in 2014, or price will close the gap as it has in the past. There is no bubble if investors have correctly anticipated a three times acceleration in growth.

SPX is now trading at 16.2x TTM EPS, which is about 10% over the mean and it's greater than at the 2007 high. It's high, but it's not bubble high.

But this misses a basic point: high valuations go in hand with high growth. When SPX has traded at higher multiples in the past, EPS growth has been 10% or more. Right now, there's a premium valuation on low growth.

BAML notes that the RUT is trading at 18x forward earnings, a 2 point gap above the large cap indices. Since 1979, when RUT has been this expensive, the return over the next 12 months has averaged minus 1% and small caps have underperformed large caps by 500 basis points (here).

Will EPS accelerate next year?

The stock and real estate crash in 2008 whipped out $16 trillion in household net worth. That is equal to one year of GDP. It is also equal to 25% of the total accumulated household net worth pre-crash. This is why consumption has been weak the past five years.

The period from 2000 to 2007 was a debt orgy. This fueled a bubble that inflated consumption. Hence, the strong growth in sales. Put another way, the high growth during the 2000's would not have happened without the rapid rise in debt financing.

Households are in the process of reducing debt to levels that were present in 2000. They have a long way to go still. If this is the 'new normal', growth will likely stay subdued over the next several years. This means organic growth of 2% plus a percent or two in buybacks, or roughly 3-4% growth, is to be expected.

Two worthwhile reads on this topic are here and here.

If there is a boom in global growth around the corner, we will start to see it in commodities. This has been a theme of ours in recent weeks. The CRB index is not indicating any pick up yet, but the table is set.

Copper is on a 'higher low' trend line with a possible MACD cross. It's the commodity with a PhD in economics, or at least it was. Watch it.

Macro data is not showing much growth, yet. Both employment and personal consumption are growing at 1.5%.  Inflation based on this weeks data is the lowest since 1965 (here).

Our current plays on a potential rebound in global growth are oil and emerging markets.  The risk-reward in oil is favorable at the moment. A breach of the recent low and the long term channel proves us wrong. Seasonality and sentiment further support this trade.

There is value in emerging markets relative to the US. Make no mistake, it needs the US to perform well in order to succeed. But if the US is set to accelerate, EMs should outperform. Unlike Developed Markets, funds are underweight EMs.

Growth + value + fund flows are a powerful combination.

Goldman and the other big banks expect SPX to rise another 6-10% in 2014. History is not on their side, but this has recently been a market that thrives on disregarding prior patterns.

2012 and 2013 have both been big years for equities. Aside from the bubbly 1995-99 period, a third consecutive big year has not happened in the past 40 years (data from Ryan Detrick).

2014 is also Mid-term in the Presidential cycle. When the first year of the 4 year cycle has been as strong as it has been in 2013, the following year (2014) has averaged a gain of 2% (data from Stock Traders Almanac).

Two other charts to watch.

First, we were shaken out of treasuries on Wednesday. They have been correlated with equities and so reclaimed lost support on the Thursday-Friday rally. Strength in equities next week may help lift them further.

Second, the SOX follows its 50-dma very well; when it has fallen below, SPX has corrected (top panel). Semi's are lagging the overall market. According to Tony Caldaro, in the past 20 years, they have not run an 'up cycle' for longer than 17-months. December would the 17-month of this expansion (read). So watch the SOX as they lead the rest of the tech sector.

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There will be no Fat Pitch update next weekend. Enjoy your Thanksgiving holiday.