Some Alarming Contrarian Indicators

In our last post we stated that while the market remained in a sustained uptrend, we'd noticed some indicators that had started to flash caution signals.  Today, the Bank of America-Merrill Lynch monthly global fund manager survey (FMS) was released and it comes at the appropriate time as the market is experiencing its biggest down day of 2017.

There are some data points in the survey that serve as contrarian indicators and others that highlight potentially crowded trades.  To top it off, the S&P is currently breaking the uptrend line from the pre-election lows.  Are we finally getting the pullback that everyone has attempted to predict?  Lets get to the facts...

Below is the summary of the FMS survey straight from BAML:

"Bottom line: March FMS shows investor sentiment in a “bullish holding pattern”; cash can fund H1 upside but FMS Positioning & Profits argue for March/April risk rally “pause”; Policy the key catalyst for “Icarus trade” to fly higher in coming months."

These are some of more interesting data points from the FMS:

Crowded Trades:

• The 2 most crowded trades are long dollar and long banks
• The dollar has a potential bearish head and shoulders top while challenging the uptrend line from 2016 lows.  
• Banks via the KBE index are rolling over as they took out the Jan 2017 lows and are now negative on the year.

Rotation

•  Fund managers favor Emerging markets over US and more defensive sectors (utilities & staples) over more volatile sectors like energy.

Equities Overweight:

• Equity overweight is highest in almost 2 years
• However allocations to US equities dropped sharply to net 1% OW from net 13% OW last month.
• As we see above money has rotated to Eurozone as equities rise to 11 month highs to net 27% OW

Overvaluation

• While this measure can stay extended for long periods it is flashing contrarian readings favoring a pullback in the US dollar.
• The second chart confirms why fund managers are rotating into EM equities vs. US equities.

Summary

Fund mangers seem to be rotating into undervalued markets and defensive sectors.   The pullback today in financials flashed a perfect contrarian signal as it was the second most crowded trade.  The S&P 500 is having its first 1% down day since October 11th, 2016.  That represents 109 trading days since the last 1% drop.  This coincides with a break of the clearly defined uptrend from the election lows.  We have been raising cash the last few weeks because the evidence didn't suggest being too aggressive at current levels.  However, we maintain that this is a bull market and pullbacks after a sustained run are normal and should be looked at as buying opportunities. 

What's On Tap?

The S&P continues to operate in a strong uptrend.  While momentum may have stalled a bit since the March 1st high, the overall trend remains healthy.  A longer-term chart shows that the S&P has broken to the upside of a huge wedge pattern.  The question is: does this propel the market higher or could it be a false breakout?

While we think this market more resembles a 2013-type of rally environment rather than the chop of 2014-2016, we want to be on the lookout for potential cracks in the armor.  We offered up some stats in our last post that confirmed our bullish bias however we also know markets don't go straight up and even in strong years like 2013 there were plenty of small pullbacks and consolidations.

Below are some of the measures we're watching that may be a tell for a pause in the uptrend. 

• High Beta vs Low volatility ratio has peaked
• The current weakness in oil
• The pullback in high yield and junk bonds
• Small cap weakness
• Narrowing leadership
• Length of current move without correction

A longer term chart of the S&P 500 showing the breakout to the upside of a large wedge formation.  It this real or fake-out?  Only time will tell.

Every time the high beta vs. low volatility ratio peaked and then broke its uptrend the general market has also peaked and pulled back. 

Oil and Junk Bonds had a rough time last week while small caps have underperformed by a wide margin over the last month.

The % of stocks above their 50-day moving average continues to lag as the S&P has rallied.  This measure peaked in January and for the market to sustain its momentum, leadership will have to widen.    

We've now gone 90 days with out a 5% correction.  Getting long in the tooth? Perhaps but today's rally (post-Fed hike decision) in everything except the dollar could offer more fuel to the bull thesis over the near-term.  

Assessing the current market and a look ahead to March

March:

• The last 20 years the average March has been bullish with an average gain of 1.85% and typically trends higher all month.  It ranks as the 3rd best month of the year.

• Since 1950 March ranks as the 4th best month with an average gain of 1.25%.

• If we get a positive January and February (like we have in 2017), March returns are better with an average gain of 1.5%.

• The full year average gain is roughly 20% when January and February were positive.

• Also, the average drawdown in March is much less severe when January and February are positive.

 

The weekly blog from Fat Pitch had a number of stats about the current market.  The most interesting looked at the average yearly gain in the S&P 500 when January and February were both positive.  "The third long term study relates to seasonality. Specifically, with two days left in February, the SPX has risen almost 6% YTD. In the 27 prior instances since 1945 that SPX has been up in both January and February, it has closed up for the full year all 27 times. The average full year gain was 24%; in only 2 cases was full year gain less 10% (from CFRA)."

Below we ran our own study below that looked at every March period since 1950 when January and February were positive.  It then calculates the yearly gain for the full year when these conditions were present.  Our work confirms the CFRA numbers. 

The above data is consistently positive.  A few factors we track that could derail the market's current momentum would be: sentiment, breadth, VIX, and length of the current move.  Sentiment in and of itself shouldn't be used to identify tops but once you couple it with a bigger move and a deterioration in breadth it can help identify turning points.  Since 2009, there have been 19 "small-ish" corrections ranging from 4% to 9%.  The average number of trading days between one of these pullbacks lasted 46 days.  The current uptrend has lasted 77 days since the last pullback of at least 4%.

That could be a signal of things being a bit overdone and perhaps this move soon exhausts itself.  Out of the 19 streaks only 4 have lasted longer than the current market move with the longest lasting 140 days.  If we look at a simple breadth measure of number of 52-week new highs in the S&P 500 (Middle Chart in orange) we can see how breadth peaked in December.  Various other breadth measures also confirm the lack of participation as the general market continues to make new highs.
To add to this, the market remains overbought as the RSI shows in the bottom panel.

The 2nd chart below from Nautilus Research looks at the forward returns of the S&P over the last 20 years after being up for 5 weeks in a row while also reaching a multiyear high (this current streak is the 15th such instance).  The results back up the idea that we could be due for some weakness in the near-term,

Overall, the market continues to drive higher and climb the wall of worry.  The stats favor a bullish tone for the month of March and the rest of the year for that matter.  However, looking at the average drawdowns and with breadth starting to lag the current momentum, we wouldn't be surprised to see a small pullback along the way.  We remain bullish and contend that any pullback/correction will most likely be shallow and short.  Unless circumstances change dramatically, the overall market remains strong.

What To Expect In February...

With January now in the books and the S&P having advanced 40 points, we looked back at February's past to see what might be in store for stocks in the coming month:

February Stats

• Going back to 1950 February is the 4th worst month with average gain of just 0.04%
• However it is also the 4th least volatile month
• Over the last 20 years it ranks as 5th worst month with average loss of -0.18%
• Over the last 10 years it ranks middle of the pack as it's the 6th best month with average gain of 0.39%.  However it's also been the 3rd most volatile month
• Post-Election years lean bearish

Last 20 years average Daily Trend.  No real consistency as the month is choppy.  

Post-Election Years

• Average return is a loss of -1.84%
•  9 of 16 February's have been lower
• Average draw-down from January close is almost twice that of the average draw-up
• -2.99% average loss in instances where the incumbent party lost
• Average loss of -2.40% when a Republican has won

While the stats above lean in the bearish camp all hope is not lost.  If we look at the average February following a positive January the story gets more positive.

• Average return is a positive 0.65%
• 64% of February's have been positive when January was positive
• Average draw-up from the January close is 90bps greater than the average draw-down

Dow In Tightest Range Ever: A Case for Short-Term Weakness

Friday's close made it official that the last month has been the most narrow 21-day (a full trading month) range (1.42%) in the history of the Dow Jones Industrial Index .  In other words, things have really stalled out.

With this in mind, we went in search of other narrow periods to see how the index performed over the following weeks.  The results were actually different than what we anticipated.

Returns in the Dow are weaker in the short-term looking out 5, 10, and 20 trading days versus the whole sample.  We do believe in the "trend is your friend" mantra and the path of least resistance remains up.  However, the data below suggests that we could be in for some slight underperformance before we resume higher.

Heading into the inauguration it wouldn't surprise us to see a volatility event as the VIX has been asleep for some time and the kick-off of the Trump presidency might serve as the perfect catalyst.

The big question we have: Is the selling the inauguration too obvious of a play at this point?  Everyone seems to be talking up this strategy.

Below: All instances where the 21-day range of the Dow was less than or equal to 2.25%.  We filtered out clusters. 

Where Do We Stand?

Overview and Technical View:

The S&P has been consolidating since the December 13th high of 2,277 and has hung around the 2,270 level for several weeks now.

After the big surge off the November low (9.3%) and the presidential election the index has decided to take a breather.  This has allowed some excessive overbought readings (rsi, stochastics, mcclellan) to be worked off.  And as the market got extended during the post-election rally, momentum in the form of breadth exhausted itself which caused the slowdown in price movement.

Yet this week we've started to see a resumption of breadth and momentum in a number of readings.   On January 4th the number of stocks up 4% flashed the highest reading since November 11th.  Couple that with multiple 80%+ days on NYSE Advancing Volume Ratio and we see some credibility that the market may be poised for another leg higher.

We're not much for putting price targets on markets but looking at Fibonacci extensions from the two years of congestion that the S&P is emerging gives us a soft target of 2350 at the the 161.8 extension level. 

Index's and Sectors

• From an index and sector view the technical picture looks positive.  All 10 major S&P sectors reside above their 50-day moving average joining the four major domestic index's.  Globally 6 of 9 major non-US markets are above their respective 50 day moving average.  
• From a seasonality standpoint January has averaged a loss of -.03% over the last 20 years.  This would put it in 8th place versus all other months.  The average daily trend of the S&P 500 over the last 20 years shows the typical peak coming in the first week of January.
 

Sentiment  and Volatility

• AAII bullish sentiment at 46.2% was the highest reading since November 23rd.  This marks the 8th consecutive week above 40%.  
• The CNN Fear and Greed Index stands at 67 flashing a Greed Signal however it is down from an Extreme Green reading of 83 one month ago. 
• The VIX is at 11.10 and has started the first week of the year down 20%

Leadership:

Banks have been the leaders of this market and continue to be on solid footing.  The group as a whole remains extended while digesting gains from November.  A look at GS tells the story.

Infrastructure plays (steel, chemicals, materials) are right behind banks in leadership.  Some have pulled back and could be setting up for another run higher.

Yesterday brought some rotation into FANG and growth stocks that have lagged the current leadership but are slowly emerging as a few rallied above their 50 day moving averages on volume the last few days.   NFLX remains the leader in the FANG group as that is testing all-time highs.

The Bulls Have Taken Control: Can They Keep It?

As we noted in our last last post, the post-Trump rally has been accompanied by a huge thrust in breadth.  The signals we noted in that post suggested that the recent action was indicative of some notably bullish outcomes looking out 3-6 months and beyond.  If we considered just the stats, it was a screaming buy signal.

Yet, given the environment and market action of the last two years, many investors have felt a bit gun-shy (perhaps, rightfully so) to step in and buy here.  Not only have they been humbled by a choppy, mean-reverting market since late 2014, they’ve also been forced to consider the ramifications of the likely Fed rate hike that we’ll be seeing in a few days.  Is it fully priced in?  What’s the reaction going into year-end? Are we moving from a QE induced bull market into an earnings driven bull market as analysts like Raymond James' Jeff Saut has been proclaiming for some time now?

"Students of stock market history will recall secular bull markets tend to have three legs. If Mr. Tuey is correct, we are barely into the second leg of this bull market, which as previously stated, he thinks is going to be, “The longest and strongest leg of all.” Of course that “foots” with our thinking that there is at least another seven to eight years left in this secular bull market. In fact, Tom Lee, sagacious captain of FundStrat, recently published a chart showing the potential for this “bull” to extend into the 2029-2034 timeframe. That seems a touch long to us, but heck, if that’s what the markets give us, we will certainly take it! I did find Tuey’s closing comments, in Gary Lamphier’s article, intriguing: “The second key point is that for the past 100 years or more, the more severe the economic downturn, the more powerful and enduring is the subsequent bull market. When you’re faced with financial Armageddon as the U.S. was back in 2008, the Fed eases much more aggressively than ever before, and they stay accommodative for much longer than normal.”

To be sure, all of this fits with our thesis the equity markets are transitioning from an interest rate-driven to an earnings-driven secular bull market. To that point, many of y’all know we are on an email “string” with folks like Arthur Cashin, David Kotok, Dennis Gartman, Bob Pisani, etc. It is a freewheeling exchange of thoughts that provides very interesting insights. Last Thursday, the savvy Bob Pisani wrote this:

President-elect Trump's proposed nominee for U.S. Treasury Secretary, Steven Mnuchin, said on our air yesterday that the administration was still targeting a reduction in the corporate tax rate from 35% to 15%. The current 2017 estimate for the entire S&P 500 is roughly $131 per share. Thompson estimates that every 1 percentage point reduction in the corporate tax rate could "hypothetically" add $1.31 to 2017 earnings. So do the math: if there is a full 20 percentage point reduction in the tax rate (from 35% to 15%), that's $1.31 x 20 = $26.20. That implies an increase in earnings of close to 20%, or $157. What does that mean for stock prices? The S&P is currently trading at a multiple (PE ratio) of 17, high by historical standards. Applying that 17 multiple to earnings of $157, we get a price on the S&P 500 of roughly 2,669 for 2017. That is 469 points or roughly 20% above where it is today.

Our sense is the new administration will not be able to get the corporate tax rate down to 15%, but even at a 25% rate, it implies an additional $13.10 to the S&P 500’s bottom up operating earnings number ($1.31 x 10 = $13.10). Using Bob’s same math produces an earnings estimate of $144.10, and at 17 times earnings, it renders a price objective of roughly 2450 for the S&P 500.

The equity markets have rallied hard on the belief in a pro-growth administration, reduced regulation, lower taxes, increased infrastructure spending, a reset on trade toward the benefit of American companies, and the reflation trade. If this optimistic scenario comes to fruition, the Penn-Wharton Budget Model targets between a 1.1% and 1.7% increase in GDP growth beginning in 2018. If true, GDP growth could ramp to ~3%+, suggesting stocks are not all that expensive. Verily, we have never wavered on the belief that we remain in a secular bull market. Such bull markets typically last for 14-15 years and tend to compound at around 16% per year. If past is prelude, we should have another seven-plus years in this “bull run.” Will there be pullbacks? Of course there will be, but pullbacks should be viewed within the construct of a secular bull market." 

For those that have mustered the courage to aggressively buy this rally, they’ve also been afforded some ripe opportunity to outperform through stock-picking.  We track the daily correlation of the underlying S&P sectors and our data shows the measure falling to its lowest level since August and before that late-2014.  Taken a step further, the data is also borne out by the clear divergence in performance for said sectors.  Being positioned in financials, energy, industrial, and materials has well outperformed laggards like utilities, consumer staples, technology, and health care over the last month.

Also favoring the bulls, was yesterday's major push higher in the number of stocks on the NYSE making new 52-week highs.  The tally was the highest reading since 2013 and according to Nautilus Research it marks a significant technical feat and confirmation that bullish conditions are afoot.  Their findings show that when the S&P 500 makes a new high and is accompanied by a new high in the 52-week individual stock reading (as happened yesterday), the market continues higher.  Going back to 1990, this setup has occurred 16 times and in every instance the S&P has been higher one year later by an average of nearly 15%.

We are aware that this market is now overbought on multiple short-term conditions.  Also in the last few years the above indicator has been a good tell for potential short term tops and bottoms.  So if nothing has changed and we're still in the same environment of the last two years, then we could be closing in on a near-term top.  

However if we are entering a new market environment in which a trend can be sustained ala 2013, we can be confident in sticking with the trend and going in search of bigger profits.  If this is the case, and we are entering an earnings driven market the argument for active management could be coming back into vogue.