Friday, December 1, 2017

How will market finish the year?

  • Last 20 years: December ranks fourth in monthly performance with an average gain of 1.47%
  • Last 20 years: The average daily trend starts strong then fades mid month only to finish close to the highs
  • Last 20 years: October is the least volatile month 
  • Since 1950: December ranks 1st in monthly performance with an average gain of 1.62%
  • Since 1950:  December is the least volatile month and is higher almost 75% of the time
  • Since 1950:  If the S&P is up greater than 15% through November, November was positive, and November hit a new high, the average return for December is 1.92% (10 prior instances)

The general market remains firmly in an uptrend and bull phase as the S&P, Dow, NYSE, Russell 2k have all hit new highs in November.  The Nasdaq is slightly below new highs with recent rotation out of big cap tech on Wednesday as managers seem to be positioning their portfolios in financials and small caps with the prospect of tax reform before year end.   While the overall trend remains up and the seasonal data presented above is favorable for the markets to finish the year strong we always look at all the data to shape a thesis.  There are certainly more than a few indicators flashing a cautionary sign as the indexes have become overbought in recent days.  Strong markets tend to stay overbought and this year is not different.  However from a tactical standpoint we always try to survey the whole landscape to make more informed decisions.  The S&P has flashed overbought conditions with respect to RSI, Stochastics, Bollinger Bands, etc.  The CBOE equity put call volume ratio hit a new low for the year as traders remain very complacent.  The CNN fear and greed index is showing levels of green but well off extreme levels earlier this year.  All of these overbought conditions are not a reason to sell but rather raise our level of awareness to a potential consolidation or pullback in the ongoing upward momentum.  A recent post from the always informative fat pitch blog focuses on a data point that shows the unfavorable risk-reward conditions over the next few weeks. 

In summary, as we head into the last month of the year we continue to favor the long side of this market.  As always, there are some warning signs from a tactical standpoint that have heightened our senses.  From a risk management perspective we have continually raised our stops on existing positions while looking for opportunities from sector rotation and pullbacks in current leaders.  At some point the markets will have a real correction of more than the measly 2.9% we have endured so far this year.  That outcome may have to wait until 2018 as investors put off selling winners into the new year on the prospect of tax reform. 

Tuesday, November 14, 2017

November Fund Manager Survey

Over the past few blogs we have looked at why the market could be due for a pullback.  Outside of the Russell 2k the majority of the big indexes have lugged higher with a persistently strong trend.  As we enter the historically strongest 3-month period in the market and with the potential for tax reform on the horizon we remain bullish till year end.  What we found interesting in the monthly data is that if we only looked at the last 20 years the trends change.  This certainly has a lot to do with the 2 major bear markets we have experienced but nonetheless the findings are intriguing.  Especially the weakness in January the last 20 years versus the larger time period.  Considering the strength of the market this year it would make sense to push off selling winners until 2018 especially if tax reform is accomplished.  This could bring in some volatility in the beginning of the new year.  Below we look at the monthly performance of the S&P 500 going back to 1950 and the most recent 20 year period.  Since 1950, the Nov-Jan period is the strongest 3-month period historically.  If we limit it to the last 20 years it ranks as the 5th strongest 3-month period, although November and December are very strong in both time frames.  This should bode well for a strong finish to year end. 

In our role of portfolio management we always want to play devils advocate and poke holes in our thesis so we don't turn a blind eye to potential pitfalls.  The data above certainly paints a bullish picture the next few months.  In our last blog on divergences we highlighted how momentum has peaked creating a negative divergence.   Below we look at the recent weakness in high yield and what that may forecast for the equity markets.  We can see in 2017 when high yield index has broken down this leads to a slow down in equity markets.  Is this time different?  We don't have the answer to that but it is something we continue to monitor. 

If we turn our attention to the monthly fund manager survey (FMS) from BAML, there are a some levels that are flashing a more cautious tone.  Below is a recap of the current month takeaways straight from the November report.
  • It’s frothy FAANG: big market conviction in Goldilocks (+ price action in FAANG/BAT,
    Bitcoin) leading to bull capitulation; FMS risk-taking hits all time high (Exhibit 1), cash
    decisively lower despite record high saying equities overvalued (= irrational
    exuberance)…our conviction in winter post-tax reform risk asset correction hardens
  • Consensilocks: all-time high Goldilocks expectations (56% expect “high growth, low
    inflation”); contrasts with tumbling bear view of secular stagnation as macro backdrop
    (was 88% Feb’16, now 25%); US tax reform expected to sustain or inflate Goldilocks
  • Ever closer to the sun: Nov FMS cash level drops to 4.4% from 4.7% = lowest since
    Oct’13 & no longer a “buy signal”; FMS hedge fund equity exposure at 11-year high;
    BofAML Bull & Bear Indicator up to 7.2 but sell-signal not yet triggered
  • Correction catalysts = inflation & market structure: biggest FMS risk to EPS =
    wage inflation; rising FMS concerns re “market structure” (3rd biggest tail risk);
    strategies most likely to exacerbate correction…vol selling (32%), ETFs (28%), risk parity
  • Notable FMS takeaways: crowded trades are #1 long Nasdaq, #2 short volatility, #3
    long credit; highest global equity OW since Apr’15, highest Japan OW in 2-years, an epic
    FMS UW in UK assets, and big Nov rotation to energy from bank stocks
  • Contrarian stagflation trades: long UK, short Eurozone; long pharma, short banks;
    long utilities, short tech
The first few charts should be grouped under opposite opinions.  There are a record number of managers taking higher than normal risk as hedge funds net equity exposure rises to an 11 year high of 47%.  In the same breadth those same fund managers say that equities remain at excess valuations but are putting cash to work with cash levels falling to 4.4%.  Our own opinions make us think that under-performing fund managers are willing to risk capital over the next few months to try and catch up to their benchmarks regardless of the stretched valuations presented.  From a global economic outlook the data remains favorable.  This is displayed in the fund managers expectations of the global economy in the next 12 months.  Expectations in the "Goldilocks" scenario (above-trend growth and below-trend inflation) rose 8ppt to 56% which is another record high.   

We'll leave you with one more data point we recently read that pique our interests.  Jason Goepfert from Sentiment trader wrote this last night:

The S&P’s split personality.  Last week, there were a lot of buying climaxes (reversals from 52-week highs) in S&P 500 stocks - 32 of them, which was up from 20 the prior week. There were also a lot of selling climaxes (reversals from 52-week lows), 17 of them, which is highly unusual in a week when there were so many buying climaxes. Usually there are many of one or the other, not both. The only time we’ve seen so many of both kinds of reversals, showing a highly split market, was in March 2000.

Once again we have presented alternative view points for both bulls and bears to consume.  We remain firmly in the bullish camp as we continue to operate within our secular bull market assumption.  However with some negative divergences appearing along with some inflated conditions to the upside we have some cash on the sidelines to put to work on any weakness as we look for a strong close to year end. 

We hope everyone has a safe and wonderful Thanksgiving!  We certainly are thankful over at Worch Capital for all blessings we have. 

Tuesday, November 7, 2017

New highs but signs of divergences

The market indices continue to chug along as they steadily make daily new highs with the exception of small caps which have lagged recently.   We have not touched on correlations of late but this has proven to be the year of stock picking.  During most of the QE environment from the market bottom in 2009 correlations remained abnormally high as asset classes and sectors followed each other in the same direction in a herd mentality fashion.  However sector correlations have completely diverged throughout 2017 and are hitting the lowest levels by a wide margin.  Below we look at the 30-day average correlations of the major S&P 500 sectors.  We overlaid the trend of the S&P 500 during the same time frame.  It clearly illustrates how 2017 has been a stock pickers year as correlations have collapsed.  We believe this is another endorsement for active management going forward.

Below is a great blog post from Chris Kimble that highlights the divergence in equal and market capitalization indexes.   This shows how a few big cap stocks (think FANG stocks) that have performed well are propping up the indices.  The equal weighted indexes are under-performing the cap weighted indexes by a whopping 25%.  We also see this divergence in our own breadth indicators.  One simple one we follow is the amount of stocks trading above the 20 and 50 day moving averages.  The second chart shows how momentum has peaked prior to price displaying a negative divergence.  This usually is resolved to the upside but we can see typically when momentum fades this tends to lead to a level of consolidation or pullback before breadth picks up and momentum resumes. 

The S&P remains overbought and with momentum fading we could be in for some short term weakness as the market digests the recent gains.  However, as earnings season had been favorable to equities and with the potential for tax reform this should keep a bid in the market.  Coupled with correlations at multi-year lows this sets up nicely for an active manager assuming you are positioned in the right areas, as we think the strong will get stronger and the weak performers will be under tax selling till year end. 

Wednesday, October 18, 2017

Are we due for a pullback?

This is a question we are constantly asked and one we find the hardest to answer.  If we knew every time the market was going to pullback we wouldn't be writing this blog, instead we would be counting our dollars.  What we attempt to do is weigh the evidence presented and trust our research while making educated bets.  We wanted to start with a simple picture of the current landscape and move on from there.

Below is a chart of the S&P with a simple 14 day RSI.  We know from historical data that an overbought RSI doesn't necessarily mean we are due for weakness.   In some instances it is forecasting future strength and in other cases it anticipates potential pitfalls.  The data going back to 1960 shows no statistical edge going out a few weeks or months trying to predict an overbought RSI.  In previous posts we have referred to prior strong trending years for comparison purposes.  We still believe these to be true and why we are highlighting this below.  1995 was one of the strongest trending years in recent past and we can see that the RSI stayed overbought for much of the year while the S&P trended higher.  The 2013-14 market had multiple instances of an overbought RSI all the while the market trended higher for months.  This year is shaping up much in the same fashion as these two years.  What we have noticed is that in most cases when the 14-day RSI became overbought the S&P went on to consolidate or pullback in the near future.  As with any indicator it is not full proof but it is something that we watch and heightened our risk metrics. 


Next we wonder if the S&P has broken out to the upside from its 12 month ascending wedge pattern.  The path of least resistance is higher and if we do get a pullback we'll be watching the top of that channel for support.  What we don't want to see is a hard sell off back into the range causing a failed upside breakout.  This could lead to a longer consolidation. 

Another useful tool is the monthly fund manager survey (FMS) from BAML.  It always offers an interesting view on the global investing landscape and is a good barometer of current market sentiment.  Below are the key takeaways that we focused on. 

One data point that backs up the case for a potential pullback is that global equity overweight suggests risks ahead for stocks.  With global equity net overweight now at +45% this has historically coincided with equity underperformance versus bonds & cash over the next 3 months.  

Fund managers are positioning themselves for higher rates as just 3% of investors think global bonds will be lower in the next 12 months.  82% say bond yields will rise and a record 85% say bonds are overvalued.  The rotation into banks (biggest in 3 years) and Japan while selling utilities, emerging markets, healthcare, and bonds is evidence managers expect higher yields ahead. 

Cash has fallen to 4.7% but still remains high as this is a catalyst for shallow pullbacks.  Managers are waiting for any dip to put cash to work. 

Through all of our research we continue to conclude the general markets remain in a secular bull market.  One of our thesis was the strong backdrop of our economy coupled with growth in earnings is what is propelling equity markets higher.  Below supports our opinion as the expectation for macro "Goldilocks" (above-trend growth, below-trend inflation) is at record highs.  It is the first time since March 2011 this exceeds investor belief in below-trend growth & inflation as the driver of financial markets. 

In summary with the current overbought conditions along with global equity overweight we are mindful for a potential pullback/consolidation at any moment.  Yet with cash levels still high to support dip buyers and a stable and growing economy the bull market is alive and well.  To strengthen the bull case we are entering a seasonably strong period in the market that we discussed in our last blog.  With earnings season upon us, we'll be looking to put cash to work in fresh new ideas but not chasing strength blindly considering the current outlook. 

Wednesday, October 4, 2017

A look to the 4th Quarter

Looking at October data:

  • Last 20 years: October ranks second in monthly performance with an average gain of 1.86%
  • Last 20 years: The average daily trend starts slow and finishes strong
  • Last 20 years: October is the most volatile month 
  • Since 1950: October ranks 7th in monthly performance with an average gain of 0.89%
  • Since 1950:  October still is the most volatile month yet is higher almost 60% of the time
  • Since 1950:  If the S&P is up greater than 10% for the year, September was positive, and September hit a new high, the average return for the October-December period is 6.39% (9 prior instances)

We have a lot of data to sort through to shape a thesis heading into the fourth quarter.   Clearly there is a bias to the upside as Q4 is historically the strongest quarter by far with an average gain of roughly 4% and higher 79.1% of the time.  Also since 1950, the October to December 3-month rolling average is the second best streak only behind the very favorable Nov-Jan period.  A nice stat courtesy of  Steve Deppe via Wayne Whaley states:

"The S&P has been positive in each of the last six months.  Since 1950, there have been 19 previous occasions of a down month and then six consecutive positive months and in all 19 of those setups, the S&P was higher either six of twelve months later, suggesting per this one study, that the odds of a Bear Market in the next 12 months is small."

To throw a wet blanket on all the good data, if we look at how the average October fares after a solid start to the year we get some conflicting signals.  We wanted to see how October returns looked when the S&P was up greater than 10% year-to-date and September was positive which are the exact conditions heading into this October.  The average monthly return for October is a loss of -0.78%.  If we add that September made a new all-time high then October returns 0.33% which is well below the average October from the stats above.  However, it finishes strong with a gain of another 6.39% for the rest of the year.

So how do we use this data to position our portfolios?  The quantitative data from a seasonality point of view is just one in many data points that goes into our overall thinking but it certainly helps to frame an outlook.  Let's take a look at some other measures;

The healthy uptrend remains as all four of the big US indexes are above their respective 20, 50, and 200-day moving averages and all are at new highs.  In an impressive show of resilience, the S&P has been up 10 out of 11 months on a price only basis.  It doesn't get much stronger than this from a trending perspective.  If we narrow down to the 10 major sectors, 8 out of 10 reside above their 20, 50, and 200-day moving averages.  We also track 9 foreign indexes and all are above their 200-day while the majority are above the 20 and 50-day moving averages.  Equity markets across the globe are trending higher.

Breadth in the form of participation is also very healthy.  The Russell 2000 has made the biggest jump in the last month as now almost 80% of issues are trading above their 50-day moving averages.  The second chart below shows new lows across all markets have dried up while new 52-week highs are starting to accelerate.  The advance-decline line is also making new highs confirming the strong breadth of this market.  One area that concerns us on a shorter-term basis is the market entering overbought territory.  The RSI (last chart bottom panel) is reaching levels that have previously caused some stalling action in the S&P during the run up since summer 2016.

Leadership has seen a rotation in the last few weeks as small caps and value have broken their underperformance as new money has positioned in these areas.  The chart below compares growth vs value and the up-trend from the beginning of the year is now broken.  This is something we'll be watching closely in the 4th quarter.

While the AAII Index remains in neutral territory the CNN fear and greed index's is flashing warning signals as it now stands firmly in overbought levels at extreme greed.  This is way up from neutral one month ago.

Lastly we look at volatility.  We now know that October is historically the most volatile month.  However, according to our September stats blog we found that September was the second most volatile month in the last 20 years.  If you follow stats blindly without taking into context the whole picture that statistic didn't help out too much.  In fact, last month was the least volatile September ever recorded.

In summary, as we head into the fourth quarter we firmly believe in following the path of least resistance as the strength and momentum in this market could carry us to the end of the year.  The prospect of tax reform getting done has continued to keep a bid in the market.  Nonetheless, with elevated levels of sentiment and overbought conditions coupled with the historic volatility of October, we will keep some opportunistic cash sidelined as we enter earnings season.  Outside of tech, we are seeing opportunities developing within the current rotation into banks, small caps, and the energy complex.  

Wednesday, September 20, 2017

September Fund Manager Survey

The monthly fund manager survey (FMS) from BAML is out and always offers an interesting view on the global investing landscape.  This month's survey provides some new data points but doesn't deviate much from that last few months.  Fund managers continue to worry about the same set of issues while their positioning continues to be overweight the same areas.  Cash levels remain too elevated to set conditions for a market top and US equity underweight is at a 10-year high.  Below are the key takeaways straight from the August survey.
  • 3 talking points: 1. FMS says markets can remain in "Icarus" upside mode for risk assets, 2. "mean reversion" has become contrarian as investorscut expectation of higher bond yields; 3. US equity UW at 10-year high, EM OW at 7-year high as US$ bulls vanish
  • On Icarus: Sept FMS shows cash levels high (down from 4.9% to 4.8% but >4.5% ave past decade), largest jump in "taking out protection" in 14 months, lowest OW in equities since Dec'16 & smallest UW in bonds since Nov'16…no irrational exuberance yet
  • On mean reversion: rotation back to QE themes of scarce "growth" (e.g. tech - Exhibit 1) & "yield" (e.g. EM), away from "value" (Japan, banks) asinvestors shun mean reversion, slash expectations for "much higher" bond yields (+26% last Nov to 5%); energy ("value") UW largest since Mar'16, utilities ("yield") UW smallest since Aug'16
  • On macro: FMS growth optimism continues to sag (+62% in Jan to +25% today) but profit hopes rose a tad this month (+34%)…greater conviction in EPS than GDP; notable divergence in FMS perceptions of fiscal policy ("easy") vs. flatter yield curve (see Exhibit 10) shows US tax reform most obvious catalyst for steeper US curve
  • Most crowded trades: 1. long Bitcoin (up $1000 to almost $5000 early Sept), 2. long Nasdaq (up 20% YTD), 3. short US$ (-11% YTD); note longUS$ was most crowded trade as recently as Mar'17 - Exhibit 2)
  • On risk: biggest tail risk is North Korea by some margin (tallies with Sept drop in Japan equity exposure), followed by Fed/ECB policy mistake; recession in next 6 months deemed biggest potential surprise, an equity bubble least surprising
  • On regions: biggest UW in US stocks since Nov'07, biggest OW in EM stocks since Dec '10; investors have not been this UW the US relative to EM/Eurozone since 2007; weak US$ big factor (US$ now most "undervalued" since Dec'14)
  • Contrarians would belong US$, long US energy, short EM tech, long Japan banks, short Eurozone discretionary/banks
One of the biggest changes this month has to do with evolution of tail risk and the fear of a conflict with North Korea.  This has become the top rail risk in September by a wide margin.  This coincides with fund managers belief that volatility is the most undervalued asset which dwarfs the next asset by far.  Cash remains elevated and this makes sense with fund managers heightened sense of angst combined with expectations for faster global growth falling again in September as it sits at the lowest level since October 2016.  Meanwhile fund managers continue to increase their hedges as equity markets hit new highs.  Hedges had their largest jump in 14 months.  Bitcoin makes its first appearance as this tops the list of most crowded trades.  Lastly, allocation to US equities falls to net 28% underweight from net 22% underweight last month.  The last time the underweight in US was larger was in November 2007.  

In summary, fund managers have been selling US equities into strength while increasing their hedges.  After a healthy run in equity markets managers are positioning their exposure in cheaper global markets yet continue to favor growth sectors over defensive ones.  With the historically weak August and September about to wrap up we are entering the seasonally strong 4th quarter.  In the short term we have internal market indicators flashing overbought conditions as US equities have hit new highs.  As we discussed in our last blog september stats to consider, we showed how the back half of September is usually weaker.  We will be watching how the markets react to the FOMC announcement today along with any fresh data out of the Fed.  In turn, tactically we have used the strength to lighten up some positions but we maintain that any weakness should be bought as we continue to believe this market will finish the year strong.  We'll leave you with one stat that is extremely impressive from Ryan Detrick.

"Since '28, S&P 500 higher each month May - Sept ... 4Q has never been lower. Up 6 for 6 with an avg return of 9.6%. Could happen this year."

Wednesday, September 6, 2017

Some September Stats To Consider

Looking at September Data:
  • Last 20 years: September ranks second to last in monthly performance with an average loss of 0.61%
  • Last 20 years: The average daily trend peaks mid-month and finishes weaker
  • Last 20 years: September is the second most volatile month only behind October
  • Since 1950: September ranks last in monthly performance with an average loss of 0.51%
  • Since 1950:  September is the fourth most volatile month and is only higher 44.78% of the time which is the worst probability of any month
  • Since 1950:  If the S&P is up for the year and August is positive, September has an average loss of 0.17%

With the above data considered, lets look to see what September may have in store.  We know that September's typically tend to bring about weakness in stocks with higher volatility.  In fact an interesting stat on volatility from the always reliable Ryan Detrick says that: 

"The worst September ever for the S&P 500 resulted in a 30% drop in 1931. In fact, no other month has had more 10% drops than September at seven. Interestingly, January is the only month that has never been down 10% or more."

September 2017 has plenty of story lines that could lead to an unpredictable month and potential for a pullback.  As always the geopolitical climate remains hostile and has been the driver of higher volatility the last several weeksSince the beginning of the year the VIX index has averaged around 11.50.  However since the start of August the VIX has twice spiked above the 15 level.  Are we due for higher sustained volatility in the coming months?  We don't know the answer to that but September and October remain the two most volatile months in the last 20 years.  Couple that with a Fed meeting, Harvey cleanup, Hurricane Irma heading towards Florida, the debt limit showdown and a host of other headlines, and the end of September could certainly be interesting.  Now we don't expect much out of the Fed meeting with only a 1% chance of an interest rate hike but with the partisan nature of government these days the debt ceiling debate will keep us on our toes.  

Jeff Hirsch of Trader's Almanac has some interesting commentary about month-end:
"Although the month has opened strong 13 of the last 22 years, once tans begin to fade and the new school year begins, fund managers tend to clean house as the end of the third quarter approaches, causing some nasty selloffs near month-end over the years. Recent substantial declines occurred following the terrorist attacks in 2001 (Dow: -11.1%) and the collapse of Lehman Brothers in 2008 (Dow: -6.0%). Solid September gains in 2010; DJIA’s 7.7%, S&P 500’s 8.8% were the best since 1939, but the month suffered nearly the same magnitude declines in 2011, confirming that September can be a volatile month."

If we turn our attention to the technicals and sentiment we can start to paint a clearer picture.  While we remain bullish overall we have continued to be tactically cautious in the back half of summer and into September.  With some cash on the sidelines and maintaining our core positions, our patience has been rewarded as the S&P has stalled since mid-July while experiencing the largest intra-year drawdown of 2.9% during August. 

One thing we are monitoring is the negative divergence in breadth as the S&P consolidates.  The leadership has narrowed and for the market to sustain new highs it will need to be accompanied by a fresh bout of momentum.  In what has been a most unloved bull market, the S&P has now had the second longest streak without a 5% pullback since the 90's.   It has been 209 days since the last 5% fall and has blown past the streak set during 2014's strong uptrend.  With 2017's biggest pullback being just 2.9% so far it seems the S&P will experience a larger drop considering the average intra-year decline is 14%.

However, there remain many more bullish signals relative to bearish and that's why we remain optimistic overall.  The majority of major sectors and the big domestic stock indexes are firmly entrenched in longer term up trends and trade above their 50 and 200-day moving averages.  The S&P just finished its 5th straight positive month on a price return basis.  This has an upside statistical edge going out 1 to 6 months as the table below proves.  

And if we check in on the CNN fear and greed index it is showing that investor emotion currently sits in the fear range.  Meanwhile the latest NAAIM Exposure index reading is 77.04 down from the last quarter's average of 85.08. 

September has been, historically, a bad month with lots of volatility.  However, we remain believers that this is a secular bull and we'll be looking to put some of our cash to work as we near the end of this seasonally weak 3-month stretch and enter the usually strong 4th quarter.