Week In Review: Checking Sentiment & Breadth

Big cap stocks essentially went nowhere this week as the S&P 500 was down a whopping 1 basis point.  Some of the "risk-on" traits we've recently highlighted continued however as small caps (Russell 2000) showed relative strength and were up 60 basis points over the last 5 days.  All in all, the marketplace still seems to be digesting the fast and furious gains that were made in late June and early July.

With that in mind, we wanted to take a look at some of the forces at play that will determine whether the recent trend continues higher.  In the very near-term, we continue to see some negative divergences and short-term warning signs that will need to be worked off but overall things continue to look healthy for higher prices.  Hopefully any pullback will be similar to some of the past instances shown in our last blog post i.e. shallow and short

Breadth

• We're seeing some short-term negative divergences as the % of stocks above their 10, 20, and 50 day moving averages peaked out in July (1st chart)
• Also, the number of 52-week new highs on S&P peaked in July  (2nd chart)
• Good news is the longer-term looking indicator of % of stocks above their 200-day is hitting highs with the market
• The advance-decline line is also confirming price strength (A-D line in yellow in 2nd chart).  This is a good thing.

 

Sentiment

• Plenty of cash is still on the sidelines as shown by the 5.4% cash weighting of fund manager allocations (this according to the BAML Global Fund Manager Survey).
• Managers are also only 9% overweight global equities which is almost a full standard deviation below the historical average.
• CNN Fear and Greed Index is has gotten excessive and is now flashing "extreme greed."
• AAII survey is at 5 week high but bullishness is still below historical average.  Still very high neutral readings.

AAII Sentiment Survey:

Optimism is at a five-week high, as more than one out of three respondents described themselves as bullish for just the sixth time this year. 

VIX

The VIX term structure remains historically low but as we have shared in previous posts this doesn't necessarily mean we should be ringing alarm bells.

In the short-term there are a few negative divergences worth watching coupled with some sentiment measures being a bit overheated.  This becomes even more important as we enter September which has historically been the worst month of the year.

However, this is also to be expected at the beginning of what could be a new uptrend.  The so-called "wall of worry."  Case in point, according to the monthly BAML fund manager survey, investors are still pessimistic with only 23% of fund managers expecting a stronger economy in the next year. This explains their low allocations to equities and high allocations to cash.  However, the potential for more to hop aboard the bullish thesis could put a healthy bid underneath the market and keep prices propped up.

The VIX Keeps Going Lower and The Market Higher: How Long Can This Last?

There's been a noticeable pickup in VIX-related talk and headlines over the last few weeks.  Case in point, Bloomberg published this story on Tuesday:

US large cap stocks have essentially jogged in place since mid-July.  In fact, per the Bloomberg article, the "S&P has failed to rise or fall more than 1 percent in either direction for 22 straight days, the longest streak since 2014."  As this sense of relative complacency has overcome the marketplace, the CBOE Volatility Index (VIX) has fallen to a more than two-year low.  At this point with volatility crushed the way it's been, it's fair to ask "what's next?"

We scrolled back into the past in search of similar market environments.  Our general search criteria looked to identify instances where the market trended higher for months and were characterized by declining to flat volatility and persistent overbought conditions as judged by the 14-day RSI.  We also wanted to see the market essentially riding its 20-day moving average higher with max pullbacks being contained and respecting the 50-day moving average.  We wanted the pullbacks to be quick and shallow.

Below are past market periods that exhibited these traits.  We included the S&P's performance over that time and the largest pullback during that stretch:

Dec 1994 - July 1995 27.09% (-2.3%) - After a very narrow 24 month range similar to current market
 
March 2003 - June 2003 28.6% (-5.8%)

July 2006 - Feb 2007 19.4% (-2.4%)

March 2007- June 2007 12.9% (-1.5%)

*Excluded 2009 as it was a huge year and bounce off bear lows and would act as outlier.  Wanted to compare more normal periods.*

Feb 2010 - April 2010 16.9% (-2.3%)

Sept 2010 - Feb 2011 29.4% (-3.3%)

Nov 2011 - April 2012 22.8% (-5.1%)

Jan 2013 - April 2013 14.2% (-3.5%)

Oct 2013 - Jan 2014 12.4% (-2.5%)

Feb 2016 - April 2016 16.6% (-2.8%)

June 2016 - ???

The average move is 20.03% with the average pullback at -3.15%.  The moves lasted between 3 and 8 months.  These results are further supported by a study this week by Mark Hulbert where he evidenced that a low VIX is not necessarily a sign of pending trouble for stocks.

Dr. Brett Steenbarger recently posted yet another great piece about market understanding.  Part of being a successful trader is identifying the current market environment and adapting to the conditions.  Trending markets are very different from choppy markets and the opportunity sets within are not the same.  The most difficult part in this process is identifying inflection points of when we're moving from trending to choppy and vice versa.  As a discretionary trader you have to weigh the evidence presented and make your bets from there.

After 2-years of choppy, range-bound trading the S&P 500 has broken out to the upside and made new all-time highs.  So if we have in fact entered into a trending environment, you'll want to be long the market, searching for relative strength and buying any weakness.  However, pullbacks are likely to be quick and won't give you much time to buy in.

Below are a few examples of the trending periods that we highlighted above.  They show price trending and a flat to declining vix (middle panel).   The 14-period RSI is shown in the bottom panel as price remains overbought throughout the move.

1995

2006-2007

2010

2013

2016