Sunday, May 5, 2013

Weekly Market Summary

SPX entered the 2000-07 resistance zone the week of March 11. In the 8 weeks since, it has traded an equal distance (2%) above and below this level. That all changed on Friday, when SPX not only ran through the top of the resistance zone but gapped nearly 1% above it. Is this a game changer?

There are a number of positives that support this move. Most importantly, $COMPQ and $SOX seem to be leading, having broken higher early in the week. More generally, the past week was led by cyclicals; not just technology, but financials and industrials as well as discretionary sectors made new uptrend highs. And ex-US markets, that were sitting on YTD lows just 10 days ago exploded to new YTD highs. As impressive as the US market was this week, ex-US markets have recently been even more so.

The improvements in trend were also supported by breadth. McClellan has been positive for two weeks and more than 80% of SPX components are above their 50-dma. On Friday, a net 775 NYSE companies made a new 52-week highs.

Objectively, the two most important factors we track, trend and breadth, support higher prices. Add in low volatility and a dividend yield well below the yield on 10 year treasuries and you have the foundation for continued gains in 2013.

Moreover, strong advances usually continue higher. We noted in February that a 7-week in a row advance was typically followed by a higher high in the weeks ahead. That was fulfilled when the subsequent advance took SPX to the start of the resistance zone by March 11. Similarly, the now 6-month in a row advance in SPX should be followed by higher prices by the end of the year. That's the longer term set up.

The Fat Pitch is a probabilistic approach to investing in the market. It is built around the observation that (a) market patterns repeat and (b) that markets move in cycles. There are opportunities to invest when reward is a high multiple to risk; conversely, there are periods where reward is not commensurate with risk.

2013 is increasingly an anomaly and a challenge for a probabilistic approach. There is now a long list of risks that SPX has skirted: weakness in growth sectors, foreign markets, and commodities; outperformance by treasuries; declining participation and a lack of major accumulation days; deteriorating macro expectations in both the US and the G10; high bullishness among investors (here, here and here); seasonality trends; and more.

That SPX has advanced 6 months in a row without a single retrace of 5% is impressive on it own; that it has done so with so many headwinds that combined have a high probability to knock it off course makes it the most impregnable market in more than 30 years.  Imagine a bell-curve with a long tail and 2013 would be at the far end.

It is a low probability outcome that 2013 will continue to be a one-way trade with no counter cycle, however brief. In the past 33 years, a near zero cycle market has happened exactly once. The other 97% of years had at least a single drawdown of 5% and 80% had a drawdown of at least 8%.

Against those strong odds, the probability of SPX ending the year less than 5% higher is about 70%. But most of the high percentage gain years occurred after a major market bottom or a flat/down year, and 2012 was not like that (it was up 13%). Looking at similar years to 2013, the probability of SPX ending less than 5% higher is 85%.

Could 2013 defy these odds? Yes, as it has been done so far. But that is a long shot. Before Friday, 90% of the gains from November occurred by March 11. Reaching for additional reward against unfavorable risk is not our approach.

Final thought: outside of major bottoms or prior years that were flat/down, the maximum uncorrected gain in SPX since 1990 was 21% (2006-07). SPX has now gained 20.5%.  After that gain in 2007, SPX corrected 7% then rose another 15% into the top. A repeat now suggests a move to 1625, then 1510 before ending the year near 1740.