Rounding out a decade

2019 is shaping up to be one of the best years for asset class returns.  It is a mirror image of last year in which every asset class except cash posted a negative return.  We have talked a lot about how strength begets strength and that has proven consistent all year long.   As we enter the final few weeks of the trading year there is no shortage of bulls and bears as we turn the clock on a new decade.

We remain in a favorably bullish period for the markets (Nov-April) and December is one of the best months of the year with a 1.50% average gain while finishing higher almost 74% of the time.

Not only has 2019 been a great year for the equity markets it has also been one of the least volatile.  According to Ryan Detrick, "the S&P 500 has pulled back 6.8% from peak to trough in 2019. This is actually one of the smallest pullbacks we've seen in recent memory."

 

A great study from Sentiment trader trader shows the MACD indicator setting up bullish for stocks the next year.  Monthly MACD's are now turning positive for the Dow and NYSE Composite for the first time in >1 year. This is bullish for stocks on a longer term basis. When this happened in the past to the NYSE Composite, stocks went up 100% of the time 6-12 months later.



As we embark on a new decade we also enter the 4th year of the presidential cycle.  Nautilus Cap does great cycle work and below shows the S&P seasonal composite for the forth year of the election cycle which shows first half volatility follow by a resumption of the trend and strong close to the year. 

 

On thing that has been missing from this market is complete market participation.  As equity indices hit new highs the amount of stocks hitting 52 week-highs is non existent.  In fact, more stocks are hitting new 52-week lows.  Meanwhile the A/D line supports the trend which is encouraging.  This all amounts to mixed signals from participation.  We can see from the chart below the A/D line in yellow is confirming the strength in the NYSE Composite while new highs total just 19 and are strongly outnumbered by 106 new lows.

If breadth is to confirm the strength in equity market it will need participation from small caps.  They have trailed the larger cap indices all year but are starting to gain traction.  Even though the Russell 2k remains below all-time highs posted in 2018 it did make a new 52-week high recently.  If you are buying small caps you are making a bullish bet on domestic growth in 2020.  If the economy avoids a recession, which we think is likely, and the economy accelerates, small caps will be a good bet.  Economic recoveries “tend to be the best phase for small-caps,” says Jill Carey Hall, an equity and quant strategist at Bank of America Merrill Lynch. “That’s one key reason we think we could be poised for a shift from large to small.” Small-cap outperformance is one of Bank of America’s biggest bullish predictions for 2020, strategists there said this past week.

When it comes to the economy, there is plenty of supporting data for growth to resume in 2020.  There has been no earnings growth this year.  According to FactSet, Q1 earnings were down 0.2%, Q2 earnings were down 0.4%, and Q3 earnings were down 2.2%.  In fact, it will market the first time in 3 years of three straight quarters of year over year earnings declines since Q4 2015 through Q2 2016.  Yet, equities are trading at all time highs.  Why is that?  Typically, equity prices are forward looking.  The most recent jobs report just printed an unemployment rate of  3.5% which is a 50-year low coupled with a surge in jobs.  With an accommodative Fed keeping interest rates low along with the good news for the US labor market in the November employment report could help validate the acceleration in the economy and earnings picture in 2020.  

Something to keep an eye on and one the bears will point to is valuations.  The US is one of the most expensive markets in the world based on P/E ratios.  Alex Barrow from Macro Ops highlighted this in his recent weekly update.  "Looking further out though into 2020 the SPX is going to be fighting some decently strong headwinds in the form of stretched valuations absent a visible driver of earnings growth. The below chart from Goldman Sachs shows the year-to-date rally has been almost entirely driven by valuations rerating higher. Over the longer-term, this is unsustainable — especially in the US where valuations are already high. Either earnings growth will need to pick up materially or equities will hit a wall."

 

These lofty valuations has Morgan Stanley lowering expectations for the next decade.  Morgan Stanley expects the opposite for the next 10 years, as it sees valuations and returns reverting to their means. Translated, today’s high stock prices point to low future equity returns. Low bond yields necessarily mean lesser fixed-income returns. Moreover, taking on bigger risks also isn’t likely to pay off in bigger returns, the investment firm adds. “We estimate the average 60%/40% stock/bond portfolio will return only 4% to 5%, roughly half that of the past decade,” writes Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, in a client note.

As markets embark on new highs, lets check in on sentiment.  Considering the recent strength from the October lows we would expect to see overheated levels.  The CNN fear and greed index is flashing greed but is not overly excessive. 

More supporting evidence that we could get a year end rally is the NAAIM Exposure Index which represents the average exposure to US Equity markets reported by active managers.  It is elevated but still well below 2019 highs as markets sit at yearly highs. 

In summary, if earnings and economic growth accelerates in 2020 higher valuations can be justified with the low interest rate envrionment.  However, if said growth doesn't materialize the markets could be in for a volatile ride considering what they seem to be pricing in. 

Ocotber and the 4th quarter

As we head into the 4th quarter we wanted to look at the potential for the year end.  Historically, October has been associated with volatility.  In fact, since 1950 October ranks as the most volatile month with the highest draw down and draw up of any month.  From a return perspective, October ranks in the middle of the pack.

When we look at the daily trend for October it starts slow but finishes strong.  Below is the average daily trend for October for the last 20 years.  

In prior posts we have talked about how a strong start to the year typically is followed by strength till year-end.  However, a tweet by Ryan Detrick shows how the next few months could be choppy. 

Just wanted to highlight the potential for an increase in volatility as we head into the 4th quarter. 

Bear Market or Pullback?

Since hitting new 52 week highs at the end of July the market has experienced three highly volatile down weeks. Most indices are off between 6-7% from their highs.  With all the negative news and sentiment you would think we are in the teeth of a bear market and the market is going to collapse.  Is this the start of a bear market?  We really don't know the answer to that.  There are plenty of pundits that will tell you with certainty that we are doomed.  But if we step back and look at the data we can begin to shape a narrative.  As always, there is no shortage of news items and events to worry about.  Below are just a few:

China's devaluation
Trade war
HK protests
China debt issues
Yield curve inversion
Potential for recession
Slowing growth
Negative yields across the world
Gold spiking

The one thing that worries us the most, is the confrontation between China and HK.  If the PLA invades to quell the protests this could turn into a global event and the potential black swan for the markets.  According to Henrietta Treyz at Veda Partners this is going to be our modern day Tiananmen Square.  "Meanwhile, it continues to be the view of the Republican caucus and some on the Street that the ongoing Hong Kong protests and paramilitary escalation will require a robust response from both the United States and increasingly Japan based on our conversations in the last 48 hours, both in terms of economic sanctions and public outcry. There is a general sense amongst trade counsel on the Hill, particularly from within the Republican caucus (where we spend a good deal of our time considering their votes would be necessary to advance any tariff-stripping authority in the US Senate) that escalation to the scale and scope of Tiananmen Square 30 years ago is more likely than not."

Currently all this angst have driven sentiment heavily bearish and only after a 6-7% drop.   This leads us to believe that the news media has created more hysteria than reality.  If we look at the recent BAML fund managers survey it can give us a good read into sentiment and positioning.  

Below are the key takeaways from the monthly survey:

The BofAML August Global Fund Manager Survey

The nut: August BofAML FMS most bullish on rates since 2008 as trade war concerns send recession risk to 8-year high; investors slash exposure to cyclicals to buy US Treasuries & US growth stocks; with global policy stimuli at a 2.5-year low, onus is on Fed/ECB/PBoC to restore animal spirits.

On growth: 1/3 of FMS investors expect a global recession in the next 12 months, the highest since 2011.

On policy: FMS investors say global fiscal & monetary policy mix is the most hawkish since Nov'16; only 9% see higher bond yields in the next 12 months, the most bullish stance on rates since 2008.

On leverage: 1/2 of FMS investors say corporates are excessively leveraged, a new record; investors want corporates to use cash to improve balance sheets > capex or buybacks.

On risk appetite: in contrast to June, the FMS cash level did not surge as growth expectations plunged…August cash levels fell from 5.2% to 5.1%; BofAML Bull & Bear Indicator holds at3.7 (not extreme bearish though record net % say they have taken out protection).

On rotation: FMS investors sold cyclical value (Japan at 7-year low, industrials 2^nd biggest MoM drop ever), bought defensives/growth (staples, tech) & bonds (#1 most crowded FMS trade = long US Treasuries); "growth over value" highest since GFC.

On US: FMS investors say US equities are the most preferred region over the next 12 months despite 78% saying the region is overvalued; note combination of two 2^nd most extreme on record (#1 Aug'18).

On bubbles: FMS investors say biggest central bank-induced bubble risk in: #1 corporate bonds (33%), #2 Govt bonds (30%), #3 US equities (26%), #4 gold (8%).

FMS contrarian trades: contrarians should be long inflation vs. deflation assets (equities>bonds, Japan>US, industrials>pharma).

Below are three charts that sum up the fear among fund managers.   

34% of FMS investors thing a recession is likely in the next 12 months which is the highest recession probability since October 2011.

 The dominant concern of investors remains the ongoing trade war with China. 

Meanwhile the most crowded trade remains long US treasuries in a flight to safety as the Fed has started to now lower rates and global capital is flocking to US bonds. 

The recent AAII survey saw pessimism spiked to its highest level and optimism plunged to its lowest level since December 2018. Bearish sentiment is now unusually high and bullish sentiment is unusually low.

The most recent CNN fear and greed indicator shows extreme fear.  

The VIX term structure has inverted showing more fear and pessimism.

Now that we have touched on what investors are worried about and how that has affected sentiment lets look at how the charts are shaping up.  The Dow, S&P, and Nasdaq remain in uptrends and well above their Dec. 18 lows.  The one area of concerns is the Russell 2k which is making lower highs and lower lows since the 1st quarter. 

A closer look at the Russell 2k shows a classic breakdown from a diamond pattern.  Small caps have lagged all year and continue to do so.

What is interesting is the strength of the market this year has been on the back of growth.  Growth has drastically outperformed value.

Yet, low volatility has outperformed high beta since last October and the ratio chart is making a new low.  

On top of that Gold and Bonds are outperforming equities since July.  Both remain extremely oversold and reside in their upper bollinger bands on the weekly charts.  Historically, these are areas where a breather is needed.

With the data presented above you can certainly see why investors are nervous.  We asked the question earlier if this was the beginning of a bear market.  We really don't know but some stats below help the bulls case.  A tweet by @PeterMallouk says "Over the last 40 years, when the U.S. yield curve inverted as it did today, the market was up 66% of the time 1 year later and 33% of the time 3 years later. Globally, the market is up 86% of the time 1 year later and 71% of the time 3 years later. Source: DFA"

And after yesterday's plunge in the S&P you would think it spells trouble for the market.  However, a study from OddStats shows "The S&P 500 $SPX just saw its second -2.9% day in 8 sessions. Because you assume that means the market is collapsing to zero, here's every other time that's happened in the past 40 years. Last 6 events, $SPX was sharply higher a week later."

Considering 33% of FMS investors say they have taken out protection against a sharp fall in equity markets in the next 3 months vs. 51% saying they have not; the highest net score since the survey began asking the question in 2008.

On top of that allocations are heavily positioned for low growth/recession.  When we assess the data and sentiment the market is ripe for a vicious short covering rally at some point.  We don't believe we are entering a bear market but rather a correction within the ongoing secular bull.   Are we subject to more downside first?  Sure, but we still believe the market has a tailwind with an accommodating Fed and heading into an election year.  There are times when it pays to be aggressive and times to raise some cash.  We are buyers into weakness but will be prudent when picking our spots. 

New Highs - Now What?

It has been a volatile few months with the markets straight down in May only to rally in a V-shaped manner in June.  The S&P 500 is back testing new highs as this is the third test of highs going back to September 2018.  So far the last few months have played out nothing like the historical average.  Going back to 1950, the average May shows a gain while June shows a loss.  July remains one of the stronger months while August is the second weakest month.  How with the rest of the summer play out? 

One primary concern of many investors is the lagging performance of small caps.  It is last index not at or close to new highs. It remains well below the September 2018 high.  See the bottom right chart.

However, the Russell 2000 underperformance should not be a primary concern according to a study from Mark Hulbert.

Another great post from Urban Carmel at the Fat Pitch Blog highlights why investors should be more worried when small caps lead.  "By contrast, small caps are lagging. They have retained none of their gains made over the past 1-1/2 years and haven't been close to a new ATH in 10 months. Should investors be worried?  By most measures, the answer is probably not. Small cap underperformance has more often marked a low in SPX, not a high. Investors should be more worried when small caps - which are highly speculative and high beta - lead, as this has most often been a feature of major bull market tops, the reverse of the situation we have now."

One of the measures we follow to get a general sense of participation is breadth.  There remains some conflicting signs.  While the cumulative A/D line is advancing to new highs with the S&P, there are a number of other contradicting breadth measures. 

The percentage of S&P stocks trading above their 50 day moving average peaked in the first quarter and has yet to take out new highs along with the market. 

The number of stocks making 52 week highs on the S&P peaked June 7th during the start of the current rally.  It has made lower highs as the S&P is making higher highs. 

Another indicator we track and follow is a measure of overbought/oversold conditions.  We track the amount of stocks up 50% in a month.  This gives us a good idea of when a market gets excessive.  As with all indicators you have to take them in context.  Overbought signals at the beginning of a trend can be viewed positively.  However, if you get them after an extended run they can signal exhaustion. If we study the table below it gives a few clues.  We looked at every instance since 2010 when the indicator first reached overbought levels.  We removed the clusters.  The returns are weaker against the whole sample in all four time frames.  Going out 10 and 20 days is the biggest divergence in returns. 

As we remain in the challenging 6 month stretch of May through October we look to secondary indicators to confirm the trends.  The trend remains up and bullish as most indices are at or close to new highs.  Small cap underperformance shouldn't be viewed as big as a negative as the pundits make it out.  The A/D line is a broad measure confirming the trend.  However, for the markets to sustain and ultimately blow through new highs on the upside we'll need to see the secondary indicators participate. 

Have a great 4th of July!

So do you sell in May and really go away?

While it is true the next six months has been the worst on average for the S&P going back to 1950 (1.48%), it usually isn't as simple as "Sell in May and go away".   As with all statistical analysis you have to look deeper into the data and not take it at face value.  We believe you have to take into context where the market is within the overall cycle.  We believe US equity markets continue to reside in a secular bull market.  We don't think it is prudent to sell your position just because the statistical data says the S&P is about to embark on the worst six-month stretch.  Yet, even within secular bull markets there are times to be more cautious than others.  Is now the time to trim lagging positions and raise some cash for potentially better entries?

There are certainly plenty of issues to make us more cautious as we enter into the most challenging period of the year.  Valuations are high but that alone doesn't warrant immediate concern.  Most economic numbers remain robust but one area of weakness has been housing numbers the last few months.  Right now the market is stuck in a headline driven market dependent on any tweet or story regarding the trade deal.  This is causing plenty of noise and volatility.  The statistical data also creates a mixed bag of results.  On one hand, the S&P's 19 week rate-of-change is at 21%.  This has been bullish going out 6-12 months as strength begets strength.  However, in the context of the current market, the S&P has been up 4 months in a row and the strongest start to the year in 32 years.  According to Ryan Detrick the markets don't have a good track record of following up on a rally of the size.  "There are four other years since World War II that the S&P was up at least 15% to kick off the year like we’re going to be this year. Three of those years are virtually flat during these worst six months of the year, the other was 1987 when we lost about 13%.  It does seem if you have some really good gains that kick off a year, it can be kind of front-ended and you can have potentially a little bit worse returns over these worst six months of the year, said Detrick.  Fundamentally things still look good ... so maybe we can get a little bit of consolidation and a well-deserved correction after a really good bounce to kick off this year.”

Last year was a bit of anomaly as the S&P experience two corrections directly off new highs.  With the S&P making new highs in May we believe this is supportive of continued strength.  Data from UBS confirms this.  "Since 1950, after stocks set an all-time high in the S&P, their subsequent six-month return has been 4.7%.  The data also show that large pullbacks have been less likely after markets have put in records.  The market has just 11% of the time declined by more than 5% over the six months following an all-time high, compared with 18% of the time otherwise.”

Markets are made by various opinions about price on a daily basis.  If we take a step back and look at the data presented there are cases to be made for the bulls and bears.  However, we prefer to look at the data relative to the cycle.  The next six months is a more challenging period but that doesn't mean we need to be bearish.  We do believe the next four months won't be as easy as the previous four considering the magnitude of the rally.  Yet, we remain bullish maintaining our core positions but looking for better entries as we enter the seasonably slow part of the calendar as we think the back half of the year can finish strong. 

Sentiment still pessimistic

The March BAML fund manager survey gives us some insight into fund managers positioning and sentiment.  The key takeaway is fund managers remain skeptical of this rally as cash balances remain high and allocations to stocks dropped to their lower level since September 2016.  Below is a recap of this month's main themes:

BofAML March Global Fund Manager Survey

"Pain trade" for stocks is still up: in the BofAML March Global Fund Manager Survey (FMS), profit expectations rose, rate expectations fell, and cash levels fell from 4.8% to 4.6%; yet allocations to stocks dropped to their lowest level since Sep '16; there is simply no "greed" to sell in equities.

Growth & EPS expectations rose for 2^nd consecutive month: but China & corporate debt concerns linger: the biggest "tail risk" for investors is a "China slowdown" (not "trade war");asked what companies should do with cash flow, 46% of respondents said "improve balance sheet", 29% said "increase capex" (lowest since Oct'09), 18% said "increase buybacks".

Interest rate expectations fell: more than 1/3 believe the Fed hiking cycle is over, 53% say short-term rates will be unchanged or lower over the next 12 months, and FMS bond yield forecasts are now the lowest since Jul'12, a big reason cyclical stocks remain shunned.

Asset allocations look pessimistic: investors are long defensive assets that perform well when growth & rates fall, and short cyclical assets that perform well when growth & rates rise (Chart 1); allocation to bank stocks dropped to the lowest since Sep '16.

Crowds & contrarians: the most crowded FMS trade is short European stocks; overvaluation of US$ is the highest since Jun '02; relative to 20-year FMS history investors long cash;"long stocks-short cash", "long EU-short EM", "long industrials-short REITs" are all contrarian.

Rules & tools: BofAML Bull & Bear Indicator stays at a neutral 4.7; FMS cash rule & FMS volatility rule say "long risk"; FMS relative value models more defensive.

After a 20% move off the December lows in the S&P 500, fund manager still find themselves underwhelmed and under exposed.  There remains no euphoric greed even after such a strong move.  This bodes well for the bulls and the pain trade continues to haunt the bears.  Fund managers favor defensive names and cash even as their expectations for growth and profit improve.  

While 38% of fund managers say they think the Fed is done hiking rates and the fed funds futures markets are pricing in 13bp of Fed rate cuts in the next 12 months.  This still doesn't make managers bullish as equities cannot catch a bid with global equity allocation the lowest since September of 2016.  Global equity allocation stands at just 3% overweight and has only been negative once in the past 6 years.  

A slowing China economy takes the top spot as the biggest tail risk, followed by a trade war and corporate credit crunch.  These worries seem to be weighing on investors appetite for risk as only 30% of fund managers are net long equity markets, which is the lowest since December 2016 and a massive reversal from 55% net long in September 2018.

It is easy to understand why fund managers are pessimistic.  59% of FMS investors are bearish on both the growth and inflation outlook for the global economy over the next 12 months, the highest since Oct'16, cementing the return of secular stagnation as the consensus view amongst FMS investors.  This also explains why investors are only 3% overweight global equity allocation.  This is the lowest since Sept '16, a massive drop from 31% overweight as recently as Nov '18 as investors turn skittish on equities despite global stocks +12% YTD.  FMS equity allocation has only been negative once (Jul '16) since 2012.

  

Since the market top in October there has been a battle between bulls and bears and the recent survey underscores the gloomy outlook for the bears.  There is a divergence between sentiment and price which should break the market in a clear direction.  Will the bears win, and the trend turn lower on the back of slower growth and over-valued dollar?  Or is there something under the surface that has propelled this market higher in a ferocious rally straight off the bottom.  A case can be made if the bears throw in the towel and increase their allocation to equities, the pain train will endure.  We remain in the bullish camp as the price appreciation should continue with further gains.  However, that doesn’t mean there won’t be downside volatility and choppy frustrating trading ranges.  We just don’t believe the markets are ready to implode as the bears predict and hope.  The sentiment data favors the bulls and leaves plenty of room for the upside and euphoria and greed to set in as the rally continues.