Friday, February 26, 2016

Weekly Market Summary

Summary: Equities gained nearly 2% for the second week in a row, led by small caps and further gains in oil. SPY has now rallied to 197, the lower end of the target range we set in early February. If this is just a countertrend rally within a bear market, then risk/reward is now marginal. Despite the steep gains in recent weeks, investor pessimism persists: it would be remarkable if the rally ended without even a hint of FOMO (fear of missing out). Breadth also suggests further upside in the weeks ahead. Meanwhile, recent macro data strongly refutes the notion that economic weakness is the root cause for the fall in equities.

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Equities continued to rally for the second week in a row. For the week, SPY and NDX gained 1.7%. RUT led to the upside, gaining 2.7%, making the rally broad-based.

Safe havens - treasuries and gold - which had been in high demand during the sell off in equities, each lost about 0.5% for the second week in a row.

The correlation of equities with crude oil remained the strongest in more than 30 years. For the week, oil gained 10%. A strong opening for equities on Friday was squashed by a 5% intraday drop in oil.

Among the many reasons to expect a bear market in equities, an imminent recession remains the weakest. In January, real personal consumption grew 2.9% yoy. Consumption continues to be healthy: today's revised 4Q15 GDP grew 1.9% yoy, with the consumption portion growing 2.6% yoy. The meme that GDP growth is being inflated by an inventory build is misleading: GDP net of inventories also grew 1.9% in 4Q15.

The positive, reinforcing cycle the economy appears to be in is:
Better employment and wages results in rising incomes; 
Which fuels greater consumption; 
Consumption leads to capacity constraints, resulting in investment increases that further grow employment, wages and income; 
Which then fuels more consumption. And so on.

Normally this cycle moves upwards until debt levels become saturated and/or the Fed raises rates to a level that begins to curtail consumption. The household debt burden is currently near a 30 year low; previous cycles have ended when the debt burden moved to a high, tapping out consumers' ability to spend.

Non-financial corporate debt levels have recently risen (encouraged by low rates) but are nowhere near levels from the 1990s (from JPM).

Bank lending (to fund investment) has risen 8% in the past year (from Jim O'Sullivan).

The equity market most often follows the economic cycle. For now, the balance of evidence points to the cycle continuing to be on a positive (but sluggish) path. An excellent new paper on how macro most often trends with the equity market from Philosophical Economics is here.

Three weeks ago, our view was that the sell off in equities was not over. While equities should rally in the next month, there was, importantly, no tradable low (post).

Two weeks ago, our view was that equities had put in a tradable low (post).

One week ago, our view was that equities had followed through on that low, supported by very good breadth which most often leads to still higher prices (post).

If this was even just a rally within a bear market, our view was that equities should gain a minimum of 7-8%, targeting the 197-200 resistance area (post). This week, equities rallied to 197.

The point of tracking this chronology is that equities follow a narrative, and keeping track of where the market is relative to that narrative helps to frame the risk/reward in the week(s) ahead.

While macro suggests an imminent recession is unlikely, the longer term price pattern for equities remains bearish.

SPY is trading below its monthly 20-ma (blue line). In the past two bear markets, a rally that fails to close back above that 20-ma has led to a deep contraction. That makes 199-200 a critical watch out area for the current rally. If past is prologue, SPY should test that level in the next month: a close below will be bearish, a close above bullish.

A bullish tailwind for equities is positive seasonality. The March-May period has typically been good for equities, especially in the past 20 years. Note that this is the historical tendency, not a road map. December and January are also typically positive, but closed lower this year (from Bespoke).

The biggest wild card in the next several weeks will likely continue to be the price of oil. Positive seasonality, sentiment, breadth and other factors will make no difference if crude rolls over while the correlation to equities is this tight.

Crude has rallied back to its 50-dma. So far, the pattern looks constructive. Next, look for oil to consolidate near the 50-d (which then flattens/rises), push through the pivot (green line at $35) and stay overbought (top panel) as further signs that the trend may have changed for the better.

The price of other commodities is also improving. Copper traded at a 3-month high on Friday before closing lower. A close above today's high would appear to complete a base, something to watch for next week (from Peter Brandt).

SPY moved above its rising 5-dma, 20-dma and 13-ema nine days ago. On Thursday, it closed above its 50-dma for the first time in 2016. The short to medium trend is improving.

If this rally has legs, RSI(5) should stay near 70 and not drop below 50; see October 2014 and October 2015 as examples (yellow shading in top panel). Note the small loss of momentum as this week progressed, a watch out for next week.

On a shorter timeframe (60 minute), SPY continues to stay overbought (top panel) and to hold above its rising 5-dma (green line). Friday's sell off came after SPY had been very overbought: this was not unusual. The low held above the 195 "breakout" level established over the past two months.

The cleanest set up would be if that the 195 area continued to hold. But, the upward trend will still be in place so long as the short-term moving averages are not breached: the 13-ema is currently at 192.5.

We think there is likely to be more upside, but the risk/reward has obviously declined. A bear market rally gains a minimum of 7-8% and Friday's high constituted a 7.5% gain. A move to 200 would be a further gain of 2.5% from Friday's close. So, there's the potential for more upside but the low end of our target has been reached and the lion's share of the move off the low may have taken place. When longer-term moving averages (50-dma and 200-dma) are declining, rallies are considered countertrend.

Aside from seasonality, two positives suggest further gains are possible.

First, recall from last week that strong breadth most often leads to gains over the next multi-week period (post). To wit, Monday was another major accumulation day (90% up volume), the third one since the January low in equities. Moreover, most sectors have rallied past their early February highs and have regained their 50-dma. This is a positive. The laggards are financials, energy and healthcare.

Second, extreme investor pessimism persists. There was another $2.8b outflow from equity funds this week. Equity fund flows have been negative 12 of the past 13 weeks, longer than any time during the 2007-09 bear market.  Meanwhile, investors have added to the safe haven of bonds, with a further $5.1b inflow this week. Those flows have been positive 11 weeks in a row.

These flows suggest that there is very little fear of missing out (FOMO) in this rally. We would expect some improvement in investor sentiment before this rally ends. The bear market rally in March-May 2008 included several positive weeks of equity inflows, including one that was more than $20b in one week. Until there is some sign of FOMO, further upside seems likely (from Lipper and Sentimentrader).

Two investor concerns appear to be misplaced.

The first is that trading volumes are unusually low. They aren't. Equities typically sell off in a panic on high volume and then rise on lower volume as investors slowly get back in; hence the mantra "equities take the elevator down and the stairs back up." This week's volume averaged 120m shares/day in SPY, more than most weeks in 2013 and 2014. About 100m shares/day is normal; volume under 80m shares/day is anemic.

The second concern is that equities have become more volatile, and that this is indicative of instability that will inevitably lead to a collapse. A study by Morgan Housel (here) instead shows that daily, weekly, monthly and annual volatility over the past 6 years is in line with historical norms. Weekly volatility is actually at a 4 decade low.

Volatility has increased in 2016 (as measured by the width of the 2 standard deviation Bollinger Bands for SPX), but it was higher during most of 2010-12 as well as during most of 1995-2000. Recent volatility probably seems extreme as it follows the relative (and unusual) calm during 2014-15.

On the economic calendar, monthly employment data will be released on Friday.

In summary, equities gained nearly 2% for the second week in a row. SPY has now rallied to 197, the lower end of the target range we set in early February. If this is just a countertrend rally within a bear market, then risk/reward is now marginal. Despite the steep gains in recent weeks, investor pessimism persists: it would be remarkable if the rally ended without even a hint of FOMO. Meanwhile, recent macro data strongly refutes the notion that economic weakness is the root cause for the fall in equities.

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