Friday, February 28, 2014

Weekly Market Summary

Last week's singular strength in RUT carried through into this week. That index plus SPX and NDX all moved to new highs. The sole laggard is DJIA. The Euro 350 confirms with its new high; the All World Ex-US is at the highs of October and January. Overall, a very positive view.

US indice strength is mostly confirmed at the sector level. 5 of the 9 SPX sectors are at their highs (green), and XLI and XLE are close. The two notable laggards are still financials and transports.

What is further encouraging is that for most indices and sectors, their 50-dma are starting to rise again. Bottom-line: that's the trend.

What is less encouraging is that leadership is heavily skewed defensive, a by-product of fundamental growth which is positive but sluggish (last week). More on that below.

Overall, NDX has been the best performing index in the US. On the surface, this reflects positive growth fundamentals in technology. But what is interesting is this: the performance is largely accounted for by just biotech.

Biotech stocks are generally speculative. The curve over the past year has become parabolic. If nothing else, this tells you that investor bullish sentiment is feverish. On Friday, biotechs were sold off and dragged the NDX negative. Going forward, reversion in biotechs is easily the largest risk to the leading index.

SPX broke above 1850. This has been the key resistance level so far in 2014. A late Friday sell off back-tested this level, which held. Since crossing its 50-dma on February 11, that MA has not yet been back-tested, nor has the 13-ema. For SPY, those levels are 182 and 184, respectively, and that area is now thick support (yellow). Closing below it is the new line in the sand.

We pay special attention to the 13-ema. After a strong run like the current one, the first touch of the 13-ema (arrows) typically holds. Something to keep in mind on weakness for the week ahead.

The thrust out of the early February low has been remarkable. RUT is now up 13 of the last 15 days. Recall that it had been down three weeks in a row into the February low, and now its been up almost every day since.

This is noteworthy because, since 1990, whenever RUT had been down 3 weeks in a row from a high, it has always at least retested that low in the next month (post). It would be remarkable if this was the first exception (n > 30).

These breadth thrusts can often lead to consolidation in the weeks ahead. RUT has had three similar thrusts just in the past year where it was up at least 12 days in 15; the risk/reward in the next month was not so attractive.

John Murphy reaches a similar conclusion when looking at the breadth thrust in the S&P 1500 over the past 3 weeks (A/D in the top panel and the index in the bottom panel).

History was a little nicer for SPY in the short-term in a similar situation. It rose 14 days in a row in March 2010, then rose another 4.5% into April before losing 17% over the next 4 months.

What makes the example above pertinent is that 2010, like 2014, is a mid-term election year. The last 4 mid-term election cycles have a similar pattern, with a notable high in the spring followed by a significant swoon into a summer/fall low.

Looking back to 1901, that same pattern shows a typical high in April and a low in October.  Happily, the year ends positive, but usually by less than 4%. Investor timing in these years is more key than normal.

In the chart above, you can see that March typically starts strong, peaks mid-month and then ends weak. March trading starts Monday and that pattern of early strength and late weakness is typical not just of mid-term election years, but of all years (from Sentimentrader).

As noted, mid-term years typically end with a small positive gain. This fits with fundamentals as they are currently developing.

Real final sales (GDP less inventory changes) is growing at 1.7% in the latest print. That's current demand growth. Forget 'weather', that level has been consistent over the past several quarters. These numbers are also consistent with other macro data (retail sales, industrial production, rail volumes, etc).

They are also consistent with corporate earnings reports: with reporting now complete, 4Q13 sales grew 2.2% (excluding financials) and FY13 grew 1.8%. 1Q14 is similarly tracking 2.4% sales growth.  Assuming, then , that sales grows of 3-5% (nominal) in FY14 and profit margins and valuation multiples stay at their current (lofty) levels, SPX would target 1900 by year-end, about 2% above Friday's close.

The treasury market appears to be onto this dynamic. TLT is making its second attempt to break out of an 8-month base. This is occurring even as equities rise.

Institutional investors (so called 'smart money') are also onto this dynamic. After being net buyers into the February lows, they have been net sellers the past three weeks. Who's buying? Retail investors. We've seen this in the daily trading pattern as well, with early-day buying and late-day selling (chart from BAML).

All of which suggests that the Scenario 2 we laid out several weeks ago remains valid (read further here and here). Again, this is not a roadmap, but a set of expectations based on market empirics. We'll monitor the market as it develops.

Citigroup comes to a similar conclusion: their macro 'cyclical expectations model' suggests weakness in the next month, while their 'panic/europhia' model of sentiment suggests that investors are once again far too bullish.

The panic/euphoria model is also confirmed by Investor Intelligence (II), NAAIM and put/call. The II bull/bear ratio spiked above 3 again this week after reaching its highest level since 1987 in January. Prior double spikes above 3 shown in yellow.

Our summary table follows below: