Friday, October 18, 2013

Weekly Market Summary

Trend, Breadth, Volatility and Seasonality Are All Positives

10 days ago, the market's experienced a momentum kick-off. The indices, which have been traveling in 5-month channels, hit their bottom rail.  Put/call spiked to an extreme, indicating fear. This was followed by a plummet in volatility and the year's first 90% up volume day (chart). That combination of events has been a set-up for a new leg higher in the market in the past, and it appears to have been one this time as well (post).

Since then, SPX has been up 7 of the last 8 trading days.  On Friday, it closed back at the top of its channel.

How violent has this move been? Consider that at the low, SPX, NDX, RUT and 7 of 9 SPX sectors closed below their lower Bollinger band. Today, all of those closed above their upper Bollinger band for a second day in a row. That's an extreme swing.

What is particularly remarkable is the breadth of this rally. Today, the cumulative breadth of the NYSE exceeded its May high for the first time. Technicians regard this as confirmation of the uptrend (i.e., price and breadth agreement), as leadership is broad (chart). This is a positive, long-term development.

With the exception of utilities, all the SPX sectors are at or above prior highs (chart). The same is true for 3 of the 4 indices (Dow being the exception). Ex-US markets, especially Europe, are also breaking higher and confirming the US market (chart). All of this is also very positive for the long term.

So, to be clear, trend and breadth both appear strong. Add in low volatility and the start of the strongest 3-months of the stock calendar (November-January; also, 4Q up 83% of time after a strong September, here), and investors have a feel-good story.  Josh Brown summed it up well here.

Against this, we would continue to strongly caution against excessive bullish sentiment. Like the fund managers surveyed by BAML, a poll by Barron's finds bulls outnumbering bears by more than 8:1 (here).  In both surveys, fund managers are long growth/beta.

Rydex (retail) investors, similarly, are leveraged long equities to a degree not seen in more than a year and higher than at SPX tops in May, July and September this year. Make no mistake, investors are very bullish.

Back to the last 10-days: why the sudden change in investor behavior?

The short answer is fund flows. In August, fund managers were 30% overweight US equities, the third highest since BAML started tracking this in 2001. Fears over Fed tapering and then the debt ceiling lowered this to neutral this month. That money flooded primarily into Europe, which saw its highest equity overweighting in more than 6 years. A good guess is that those flows are now reversing out of the rest of the world and back into the US equities as well as bonds (post).

Short Term Set Up Into Next Week

The resulting buying frenzy has been indiscriminate (breadth) and aggressive (standard deviation bands). Consequently, the set-up into next week looks like this:
  • SPX is at its channel top. It's channel bottom held and we would expect the channel top to do so as well, at least on the first touch. Click for charts of RUT, NDX and the Dow

  • SPX made a new high and then opened and closed above its upper Bollinger today. This, in the past, has often indicated a short-term climax (arrows in chart below).  Also, see probabilities on this set up from @paststat and @WildcatTrader.

  • A majority of the 9 SPX sectors are above their upper Bollinger for two days in a row. An excellent chart from @Market_Time shows how this plays out ahead. Also note the recent cluster of these extremes.

  • The indiscriminate and aggressive buying has spiked Net New Highs. Again, spikes like this, in the past, have often been short-term climaxes.

  • Put/call has once again plummeted as investors take off hedges. Total put/call today closed below 0.7 and the equity-only closed below 0.5; both of these levels are extreme. SentimenTrader notes that options traders are showing nearly the lowest level of near term concern this year (post).
  • Similarly, the yield spread of junk to investment grade bonds is back at the same lows of mid-July and mid-September when SPX topped. There's no fear.

  • Retail investor optimism jumped to a 3-month high this week while pessimism sank to a 5-week low (here). A similar survey of bullish sentiment rose by ~50% this week (here). 
  • Cobra notes that IWM has risen 7 weeks in a row for only the third time since its advent in 2000; the next week was down in two of those.
  • Finally, seasonality the week that just finished is traditionally very strong. Next week, it is typically the weakest of October (chart). 

Macro and Earnings

Whether the longer term momentum loss, in primarily the Dow but also SPX, that we have repeatedly commented on (post) materializes is unclear. In the past 20 years, that pattern has played out every time except once: the powerful 1995 rally. With seasonality turning strong, the pattern would need to kick-in soon. Current SPX chart here

What could trigger it? Now that Washington is no longer the main risk for the markets, investors will likely focus on macro data and earnings. 

Macro data appears to be softening: both the Citi Economic Surprise indices (US and G10; chart) and Ed Yardeni's macro indicators (chart) are now falling. This is part of a rhythmic cycle (chart). Normally, stocks follow. Given potential glitches in data collection during the shutdown, these need to be given a week to confirm. 

Reporting for 3Q earnings has started (19% reported so far) but really gets going this coming week (29% will report). Expectations at the start of 3Q were for 6.5% EPS growth. By the end of 3Q, this had fallen more than half to 3.1% growth. Easy to beat, right?

So far, actual EPS growth has been just 1.3% on sales growth of 1.9%. Margins fell. This follows weak top line growth (chart).

By the end of next week, nearly half the SPX will have reported and we'll have a better gauge. Right now, the acceleration in growth keeps not materializing. Consensus was for 8% EPS growth in 2013; its now down to 5%. We have held a forecast 4% all along and will maintain that for 2013 and 2014 (consensus for 2014 is 10%).

The lack of earnings and sales is strongly at odds to the indices' price appreciation. According to BAML, the Russell small cap index is now trading at a 20% premium (18x vs its mean of 15x; article).