Joseph S. Kalinowski, CFA: July 2015

Sunday, July 26, 2015

Questionable Market Action

Concerns about the current rally are in question. This is a topic that we have been writing about for some time and the debate continues. Let’s preface this blog post by saying we are still assuming the bull trend remains in-tact. We have not altered our investment thesis and remain invested. The only alteration was a few months back we started capturing interest and dividends without reinvesting them immediately. This is a slow start to building cash for better buying opportunities.

We don’t know what will be the catalyst that starts the coming correction nor when it will occur. That said, we remain on high alert for a breakdown in the bull trend.

I’ve come across a few compelling articles about market pressures that call into question the market rally.

We Might Already Be in a Bear Market – Economy & Markets Daily: “The Nasdaq 100 hit an all-time high on Friday. It seemed time to pop the champagne and celebrate newfound riches. But what actually happened is that while the index hit a fresh all-time high, more stocks actually went down than went up! The last time this happened – when the index made a 52-week high but more stocks declined than gained – was March 23, 2000. Two days later, the bull market ended. This is not a common occurrence. Over 8,000 trading days it’s happened nine times. It happened in 1984 then not again until 1998. Then, after that day in 1998, 356 more stocks more stock went down. After three months, the market lost 24% of its value. And by early 2000, the Internet Bubble was over. Bad things happen when fewer and fewer stocks begin leading the market rally while the rest fall to the side.”

“In prior reports I mentioned that transport stocks were leading the way down. They’ve been performing poorly based on softening global demand. I’ve also warned that old-school technology companies were vulnerable. Many of them have had poor earnings reports or are hitting 52-week lows. So, we are already seeing pockets of stock market weakness. The indexes at all-time highs are only a mirage hiding the underlying weakness. Of course, unless there is an outright crash, not all stocks will go down at once. Some will signal the way for the rest, like the ones I’ve mentioned. But in my opinion, we are still in the riskiest end of the spectrum to allocate new money to the stock market. The recent price action of the indexes making new highs, with just a handful of companies carrying those highs, only strengthens my conviction.”

We wrote a recent blog suggesting the market is rallying on the backs of a few large capitalization companies and that depth has been deteriorating. We too believe this is not a good signal for things to come and will be watching closely.

The Dow just broke a pretty dubious record – CNBC: “On Thursday, the Dow Jones industrial average swung to a negative year-to-date return, the 21st such time it has moved to either side of breakeven for 2015. No other year has been so fickle, the closest being the 20 times the blue chip index swung in both 1934 and 1994, according to research compiled by Bespoke Investment Group. The Dow was off more than 1 percent for the year as of Friday. That the Dow has topped the mark with more than four months of trading to go exemplifies a lack of conviction that stretches back to November, even though the index has posted multiple record highs during the period.”

Given the run that we’ve had in the market, this kind of indecisive action can be a harbinger of negative things to come. Charlie Bilello, CMT from Pension Partners wrote an interesting article entitled The Illusion of Stability. He notes that there are several warnings on the horizon that indicate U.S. market troubles. He highlights a deteriorating revenues and earnings environment, excessively risk tolerant credit spreads, a flattening yield curve, weakening market technical internals and tightening monetary policy as a few items that paint a bleak picture. All this and yet the stock market doesn’t appear to be phased. “Collectively, these factors point to an equity market that is increasingly fragile and in the past one that was about to become much more volatile. The response from market participants today: “no one cares.” Volatility is low, stocks are still acting like a 6-month CD, and monetary policy is easy. All true, but investing is about the future, not the past. No one knows when the Minsky moment of this cycle will occur, but a necessary precursor is low volatility and the illusion of stability. Add fragility to the equation and you have a powder keg just waiting to explode.”

Staying on the subject of extreme market complacency - The clock is ticking for stocks: Acampora – CNBC: “The S&P 500 and Dow Jones Industrial average have been bouncing around in a tight range for the better part of 2015, but according to top technician Ralph Acampora, if the market doesn't make new highs soon, it could lead to major problems down the road.”

The Dow Industrials vs. Transports

Acampora goes on to state, “In addition to the lack of new highs, Acampora turned to the classic technical indicator that could be flashing a "caution" sign: the Dow Theory. "While the Dow is going sideways and attempting to make new highs, transportation is rolling over. That's not a good sign," said Acampora, director of technical analysis at Altaira Limited. Despite his concerns, Acampora is sticking to his year-end target of 2,250 to 2,300—for now. "I have to stress, we need new highs or I'll have a problem later on," he added”. Russ Koesterich, CFA from BlackRock acknowledges the divergence between the transports and industrials but isn’t putting too much weight on the readings. In his post Do Transport Stocks Signal a U.S. Selloff? He writes, “Recent divergence between Industrials and Transports would be more compelling if it was confirmed by a sharp drop in any new orders or manufacturing surveys. However, here the evidence is mixed. For instance, recent factory orders and Chicago Purchasing Managers data have been soft, but the national ISM Manufacturing index, particularly its new orders component, rebounded sharply in June. To be sure, we are witnessing an increasing number of global risks surrounding unsustainable debt and credit creation—consider this summer’s headlines out of Greece, Puerto Rico and China. These risks have the potential to further weigh on global markets, at least in the near term. However, such risk aversion is likely to be short lived, given continued central bank accommodation in much of the world and some modest improvement in economic growth. As such, we remain overweight stocks, cyclicals and credit.”

Portfolio Strategy

These are all sound arguments of events that precede market corrections. As we stated earlier, we are staying the course in our current portfolio mix and will remain so until further confirmation of market weakness. We have to assume that the current bull trend remains.

The 200-day daily moving average is still in an uptrend, the RSI (14) is approaching support, the RSI (5) is moving into oversold territory along with the fast stochastics. We anticipate further downside in the near-term and look for support at the 200DMA and improvement in the aforementioned technical readings for further confirmation about our bull trend assumption. A breakdown in these near-term indicators will focus our attention on the longer-term trend.

The negative cross of the long-term MACD and its signal line (20, 35, and 10) will entice us to start to take a much more defensive position in our programs by adding portfolio insurance and raising cash.

Bottom Line: We have been staying the course as it relates to market exposure with a keen eye on events that could alter the trend. Market internals as well as economic and fundamental data seem to be getting tired and that concerns us. We believe the markets are at important levels currently to either confirm the uptrend or signify something less desirable.

Joseph S. Kalinowski, CFA

Thursday, July 23, 2015

Not-So-Precious Metals

Precious metals of all types are trading terribly. I’ve written several times in the recent past about the virtues of having exposure to the precious metals sector, in particular platinum and palladium given their industrial usage in the auto catalyst industry. As we pointed out in previous postings, the undervalued platinum – palladium story was supported by the underlying industry fundamentals – i.e. demand outpacing supply. We also know that the fall in Chinese equities placed a crimp in auto demand in the fastest growing auto sales segment and that is hurting demand. Primary mines continue to increase production and weakened scrap and base metal prices have actually boosted secondary recycled “production” in my opinion. So the supply – demand dynamic that supported higher prices has started to weaken. We are still of the opinion that the metals at these levels will produce positive returns for those wishing to speculate in the space.

Auto Demand

Let’s start with some good news. European auto demand seems to be picking up with the help of extraordinary monetary policy procedures. According to Business Insider, “European car sales are rising at the fastest pace in 5 and a half years, since the back end of 2009. Sales rose by 14.6% in the year to June, the most rapid increase since before the onset of the euro crisis. That's according to the European Automobile Manufacturers Association.”

Bloomberg News states, “Registrations rose 15 percent to 1.41 million autos from 1.23 million a year earlier, the Brussels-based European Automobile Manufacturers’ Association, or ACEA, said Thursday in a statement. The jump was the biggest since a 16 percent surge in December 2009, when governments in the region offered incentives on trade-ins of older cars to help the industry recover from the global recession.”

This sliver of good news although doesn’t offset the auto sales troubles in China.

Toyota is holding off building the Lexus brand in China because of the country's stalled auto market – Reuters (Via Business Insider): “Toyota Motor Corp will likely delay building its premium Lexus brand in China for at least a few years, as growth in China's auto market slows to a crawl and a weak yen makes it cheaper to keep making cars in Japan.”

China Headlines: Car price war launched as sales slow – Global Post: “Chinese car dealers have launched a price war as their inventories climb amid downward economic pressure. The auto sector, which experienced years of explosive growth, saw sales up by a mere 1.4 percent year on year in the first half of 2015, when about 12 million vehicles were sold, according to the China Association of Automobile Manufacturers. Sales in June fell by 5.3 percent month on month to 1.8 million, down by 2.3 percent compared with the same period last year. Industry insiders predict this year's growth to be a tepid 3 percent instead of the expected 7 percent.”

China's economic turmoil is starting to hit US automakers – Business Insider: “Shockwaves from a drop in Chinese car demand are reverberating in Wolfsburg, Germany and Detroit, Michigan, where VW and General Motors are feeling the effects of a slowdown in a market that has been their big profit engine. Both Volkswagen and GM are heavily exposed to China, which remains a growth market, but last week cut its 2015 forecast for vehicle sales. The two car makers depend on the country for large parts of their profits and cash flow, and neither has a convincing story to tell about how to offset a slowdown in growth in the world's largest car market with other parts of their business.”

China New Car Sales Drop in June—Update – Nasdaq.com: “The global auto industry's biggest market has slipped into the slow lane, with China new-car sales registering a rare monthly decline that indicates top car companies have another headache to handle in emerging markets. Although growth has been slowing in China, most auto executives had earlier in the year been forecasting 2015 sales to grow at a high single-digit percentage pace, but that now looks optimistic. Over the first half of the year, sales rose a disappointing 4.8% to 10 million vehicles, but that growth rate was far below the gains enjoyed for several years. The China Association of Automobile Manufactures said Friday that June sales fell 3.4%, just the third monthly decline since September 2012. Unlike the past two monthly declines, which were fueled by a weeklong holiday in 2013 or political events, this skid comes as the economy slows, stock markets decline and an increasing number of analysts say the Chinese auto industry is overheated.”

Audi Said to Revise China Target as Stock Rout Saps Demand – Bloomberg News: “Audi AG has abandoned a target to sell 600,000 cars this year in China, its biggest sales region, as the country’s stock market rout sapped demand for luxury vehicles, two people familiar with the company’s plans said. The German carmaker will provide an update on the market situation when it announces first-half results on July 30, said the people, who asked not to be named because the information isn’t public. Audi’s Chinese sales rose 1.9 percent to 273,853 cars in the first half.”

Clearly slowing auto demand in China is a serious headwind for a sustainable move higher for platinum and palladium. Staying on the subject of PGM demand, I had a conversation with the folks at CPM Group a while back and while they agreed with my general thesis that PGM offered value buying opportunities they pointed out that investment demand could soon start to wane. They mentioned one investor that claimed platinum was a very small holding in his overall portfolio but it’s the one asset that keeps him up at night. Indeed if this gets to the point where investors just throw up their hands and call it quits, that can also increase the downward pressure currently weighing on PGM prices.

When looking at platinum and palladium holdings for all the known ETF’s, there are 2.7 million ounces of platinum and just under 3.0 million ounces of palladium held. There have been some minor declines in PGM holding in these funds but given the rout in PGM prices, I’m actually surprised at how well they held up. Major withdrawals within these funds will impact prices and increase the risk of “flash crashes” in the asset.

Flash Crash

Gold crashed – 7/19/15 – Business Insider: “The price of gold, courtesy of stop-loss selling and thin market conditions, endured a wild ride Monday. At 9:25 p.m. EDT, the spot price crashed 3.8%, or $43, to $1,087 an ounce in just a matter of seconds.”

There has been concern by many that the next crisis will be sparked by a liquidity trap in widely held assets. We wrote a piece a while ago entitled The Looming Crisis that highlighted the concerns. The crash in gold prices goes to show that if there was indeed a mass bout of selling, investors will have a hard time exiting the position. That is certainly enough to spark panic in the markets. The folks at Business Insider opined on the dilemma writing, “Broadly speaking, liquidity measures how easily traders and investors can buy and sell an asset in the market without seeing big price dislocations. When liquidity is low, selling can cause prices to plummet. "I think of this as one of the most underappreciated risk factors facing most investors today," Allianz's Mohamed El-Erian said in May.”

“This whole discussion about liquidity risk by the market experts wasn't about gold. Rather it was about the bond markets. Specifically, there are concerns about what might happen should the tide turn in the bond markets when 30 years of falling interest rates reverses at a time when the Federal Reserve is preparing to tighten monetary policy by forcing rates higher. "Current concerns in the financial markets center around the absence of liquidity and the effect it might have on future market prices," Janus' Bill Gross said in June. "In 2008/2009, markets experienced not only a Minsky moment but a liquidity implosion, as levered investors were forced to delever. Ultimately the purge threatened even the safest and most liquid of investments."”

China’s Gold Reserves

From Mining.com, “China shocked the bullion market by unveiling Friday its official gold holdings for the first time since 2009, putting an end to years of speculation and rumours of Beijing quietly buying gold since prices began declining According to data from the country’s central bank, China’s gold reserves stood at 1,658 tonnes (53.31m fine troy ounces) at the end of June. In April 2009, its gold holdings were 1,054 tonnes. This 57% jump in reserves means that China now surpasses Russia in the list of countries with the largest stash of the yellow metal, placing it in the sixth position, after the US, Germany, the International Monetary Fund, Italy and France, according to the World Gold Council.”

This announcement has left many underwhelmed as the figures were much lower than anticipated. So much so that there is speculation that China purposely low-balled the figure for public release.

Where Is China's Missing 1,850 Tons Of Gold? – Forbes: “The assumption that China still has not disclosed all its gold has led Lundin, like many others, to wonder “why they would feel compelled to understate the total now.”The thinking of Chinese officials about their stockpile remains a mystery, but there are various theories. The most benign comes from GoldCore’s Mark O’Byrne, who said China may have been “lowballing” the size of its holdings to maintain confidence in the dollar. The dollar, however, does not need confidence boosters at the moment, so that explanation is probably wide of the mark. Others speculate that Beijing’s announcement on Friday was intended to reassure panicky domestic stock investors. But if so, why didn’t the central bank come out with a bigger number? Surely no one would have questioned a figure double or triple the one released on Friday. Another theory is that Beijing will announce further purchases in coming months as part of its campaign to persuade the IMF in November to include the renminbi in the Special Drawing Rights basket of currencies. Call it “momentum building.” The stretching out of disclosures—false reporting—is not impossible. After all, the PBOC has no problem releasing inaccurate information on its gold reserves. The bank’s records show, for instance, no net addition to its holdings from May 2009 to this May. Incredibly, the bank officially maintains that its gold reserves increased by 19.43 million ounces within one month, this June. Given what is known about transactions in gold markets last month, that could not have occurred.”

Blood in the Streets

For gold investors, these are the darkest days. There is blood in the streets. From Mining.com, “Last week large gold futures investors such as hedge funds, referred to as "managed money", slashed overall bullish positions by a whopping 64%. The week before speculators cut long positions by more than half. Bets that prices will rise only amounted to just 7,574 lots or 757,400 ounces in the week to July 7 according to the Commodity Futures Trading Commission's weekly Commitment of Traders data. The net long positioning is now the lowest since at least 2006 when gold was worth less than $600 an ounce. Speculators' short positions – bets that gold could be bought cheaper in the future – jumped to more than 10.8 million ounces (306 tonnes), a new record high for bearish bets placed on the New York gold futures market.”

Then there are those ultra-contrarians in the market that make a case for the purchase of gold and gold mining stocks at these levels.

Daily Reckoning: “It’s ironic that China’s underwhelming gold announcement may be the catalyst to send gold to its capitulation low. But the market works in mysterious ways. I say capitulation low because that is what it’s shaping up to be. Let me tell you why. In the future markets, ‘managed money’ (basically the hedge funds) are now short a record amount of gold. Being ‘short’ means they are betting on a price fall.

You can see this in the chart below:”

This is the largest short position by this group of traders in the report’s history. And chances are it’s going to get more extreme as downward momentum gathers pace. That means you could see more downside in the US dollar gold price. But such a drop just adds fuel to the fire of an eventual rebound. Consider the following commentary from trading legend Martin Armstrong: ‘At the top, the majority is long and they become the fuel to make any market crash and burn. ‘At the bottom, the opposite unfolds for everyone will be short. They will pile on looking for $600 gold and will count their profits upon entering the trade. They become the fuel to send the market higher for it always begins with a short-cover rally; people continually try to sell each rally, looking for that new low, just as the people at the top remain convinced that a decline would follow with new highs.’ So as this US dollar gold bear market reaches its crescendo, and as the mainstream media puts the boot in about gold’s prospects, keep in mind we’re close to the bottom with an all-time record amount of punters betting on more falls.”

The Felder Report: “This prolonged pain has created an incredible degree of despair in these markets right now. Everyone hates gold today. Traders hate it. Speculators hate it. The media hates it. But only when something becomes so widely out of favor does an investor get the opportunity to buy it at such a wide discount. The more out of favor it is the greater the discount. The greater the discount, the greater the prospective return. Meb Faber recently showed us the terrific returns to be had by buying an asset class after a prolonged decline: “You doubled your returns in the year following three down years for both country stock markets and asset classes.”

Graphic via MebFaber.com

“Gold and the miners are now down nearly 4 years in a row. I can only imagine the sort of returns that degree of despair produces. And that’s just the sort of setup that piques my interest. All in all, I’m fairly certain that the gold mining stocks are now the most hated asset class in the markets. For that very reason, they may very likely be the most attractive opportunity an investor can find.”

Bottom Line: I am in agreement with the ultra-contrarian camp as it relates to PGM. While the supply – demand dynamic has deteriorated slightly over the past few months, we continue to believe this space offers an opportunity for outperformance from these levels in the months and years to come.

Joseph S. Kalinowski, CFA

Saturday, July 18, 2015

Size Matters

Google’s stock price had an unbelievable rally on Friday adding almost $67 billion in market value to the company. The total market cap for Google is now $478 billion, roughly double the size of Greek economy. This was the largest one-day market capitalization gain in history. This also got me thinking about the recent rally in the stock market and how it may be the result of the largest companies moving higher.

The S&P 500 is a market cap weighted index meaning the largest companies in the index carry the most weight in directing the movement of the index. I use the SPDR S&P 500 ETF Trust (SPY) to represent the S&P 500. Now let’s assume we assign all the components in the S&P 500 an equal weight. Using the Guggenheim S&P 500 Equal Weight ETF (RSP) as a representation of an equal weighted index we can then track the 30 day returns between the two. When there is a divergence in the two, it is usually a sign of a near-term mean reverting circumstance that can signal near-term changes in market direction. The figure below shows the tight correlation between the two ETF’s and I have expanded on the recent divergence between the two.

Historically this model has been successful in spotting turning points but has less success in helping determine direction. At the onset of economic slowdowns, smaller, less globalized companies will feel the brunt of the slowdown first, so a divergence in that case would lead the S&P 500 lower. That has not been the case for the past several years. “Buying on the dip” has been a successful strategy for the past several years as large cap companies have held up well versus their smaller counterparts and have lead the market to rally from the aforementioned dips.

We are also finding the equal – market weight Z score has been making lower highs and lower lows over the last few years while the markets continue higher. For the first time in a while the model broke down and failed to “pick the dip” the last time around. This is telling us that more and more, the market rally is less broad based in terms of market cap and is supported by the largest of companies. Case in point, the NASDAQ rallied strongly with the impact of Google while the rest of the markets were down on the day. This is of some concern but it doesn’t change our view that we see signs of the market going higher in the second part of this year. We wrote last week that we were seeing bullish signs and staying the course assuming that the trend will stay intact while understanding that the market is overvalued and we need to remain nimble in the first signs of real market trouble.

According to a recent Wizzen Trading post, we could be getting a good test of market strength in the very near-term. “SPY is near resistance now so I’d be looking to lock in gains here and in most stocks who’ve had a nice run the past few days as we approach an overbought condition. I’ll be looking to buy some stocks in the days ahead if SPY can consolidate up near 212 but if we begin to roll over then all cash is the place to be until we find support again.”

Time will tell.

The Coming Correction

We have written numerous times in the past few months that we understand the market is overvalued but know that market sentiment can be powerful fuel that can extend market multiples to new highs for years to come. That said, we question the calls for an eminent market correction on the horizon. The usual suspects that are most likely to damage the trend just don’t seem to be present. Our past musings on the genesis of a new market downturn.

7/12/15 - The Coming Market Correction?

7/7/15 - Chinese Equities are a Problem

5/17/15 - A Slowing Economy and a Wall of Worry

3/23/15 - Fundamentally the Market should be Heading Lower...So Buy More Stocks!!!

I read an excellent post this weekend on Humble Student of the Markets (an absolutely brilliant source for analysis) and Cam Hui supported the thesis that there are just not that may usual catalysts on the horizon that typically lead to a market downturn. In his piece, Back to our regular programming (of 2011) he states, “The other key ingredient of the bull case is the continued growth seen in the US economy. JP Morgan Asset Management recently wrote that past bear markets had these common features (with my comments in parenthesis):

•Recession (no sign of a full-blown recession ahead)

•Commodity spike (you have got to be kidding, commodity spike?)

•Aggressive Fed tightening (instead we have an ultra cautious Fed)

•Extreme valuation (valuations are elevated, but not stupidly high)

Bottom Line: We have to assume the bull thesis remains intact but be prepared to quickly adjust the portfolio risk profile should the market get decidedly weak. The only adjustments that we have made to date is to hold cash from incoming dividends and interest as opposed to instantly reinvesting them. We will get more aggressive in our defensive stance as dictated by the market.

Interesting Reading

I came across this article from Market Watch this week that I thought was interesting and supports our belief that the market could move higher later this year (confirmation bias?). The article is entitled Fund managers are holding the most cash since Lehman’s collapse. When reading this of course my contrarian antennas went up but to the author’s credit he stopped short of calling a market direction based on the survey. He writes, “Fund managers are holding the most cash since the collapse of Lehman Brothers because they’re reluctant to take on more risk as equity-market tumult in China and Greece’s potential exit from the eurozone threaten to weigh on global economic growth, according to a monthly survey of fund managers conducted by Bank of America Merrill Lynch. Managers are holding about 5.5% of their portfolios in cash, the highest level since December 2008. Lehman filed for bankruptcy in September 2008, sending shock waves through global financial markets.”

I stated earlier that this supported our bull thesis for the remainder of the year and should be looked at through a contrarian lens. Take a look at the previous periods when cash was raised as a result of market nervousness. They all offered pretty good buying opportunities. We'll see.

Earnings Season

We are in the beginning stages of yet another earnings season and I believe this season will be a pivotal one. According to FactSet, “For Q2 2015, companies are reporting year-over-year declines in earnings (-3.7%) and revenues (-4.0%). Analysts do not currently project earnings growth to return until Q4 2015 and revenue growth to return until Q1 2016. In terms of earnings, analysts are currently predicting a decline of 1.2% in Q3 2015, followed by growth of 4.1% in Q4 2015. In terms of revenue, analysts are currently projecting a decline of 2.5% in Q3 2015 and a decline of 0.4% in Q4 2015, followed by growth of 5.9% in Q1 2016. For all of 2015, analysts are projecting earnings to grow by 1.8%, but revenues to decline by 1.8%.”

“The blended revenue decline for Q2 2015 is -4.0%. If this is the final revenue decline for the quarter, it will mark the first time the index has seen two consecutive quarters of year-over-year revenue declines since Q2 2009 and Q3 2009. For Q2 2015, the blended earnings decline is 3.7%. The last time the index reported a year-over-year decrease in earnings was Q3 2012 (-1.0%).”

So it appears that revenues and earnings may be topping somewhat. In our opinion that signifies a clear and present danger to the bull market but we have written in the past that this deterioration needs to transpire over several quarters or perhaps years so the threat is being monitored closely but we’re not adjusting the portfolio at this time.

Another article we found that dovetails nicely into the slowing fundamental theme is CFOs: This year is going to be bad from the CNBC web site. The article states, “Chief financial officers interviewed this quarter expect earnings and revenue over the next 12 months to grow at the slowest rate in the last five years, according to a new survey by professional services firm Deloitte. CFOs expressed less optimism about the economy going forward, and a record high of 65 percent said U.S. markets are overvalued, compared to only 46 percent last quarter.”

Reading the Results

The banking sector has been leading the rally of late and several banking companies have reported their quarterly earnings. Indeed as a consumption economy the results thus far are shedding a favorable light towards U.S. economic growth. This recent post from Business Insider sums up the results well, “Bank of America said it issued 1.3 million credit cards in its earnings report Wednesday, marking the bank's highest tally since the third quarter of 2008. Wells Fargo's earnings report on Tuesday showed a rise in transactions and in accounts, a positive sign for the retail and consumer companies that will reveal their quarterly performance in the coming week. The good news for the economy also comes from data showing that payment volumes are rising, signaling consumers are able to keep current on their bills. JPMorgan also had good news on the consumer credit front earlier this week. When the bank reported earnings on Tuesday it revealed more than $125 billion in credit card activity for the second quarter, topping the previous quarter as well as the same period last year.”

Joseph S. Kalinowski, CFA

Tuesday, July 14, 2015

Opposing Views

The market is so dynamic. The ebb and flow of differing analyses truly makes every day an education for those of us that are students of the market. Here are two differing views for the outlook heading forward.

The Bear Case

Carl Swenlin from Stockcharts.com wrote an interesting piece entitled, “SPY: Longer-Term Internals Still Looking Bearish” Let’s take a look at his compelling chart-work and assumptions.

“On Thursday the DP Trend Model for SPY changed from BUY (long the market) to NEUTRAL (in cash or fully hedged) when the 20EMA crossed down through the 50EMA. Why doesn't the model change from BUY to SELL (short the market)? Because the 50EMA is still above the 200EMA, which, by our definition, means SPY is still in a long-term bull market. In this type situation the Model design assumes the 20/50 crossover is only signalling a correction, not a bear market. If a correction turns into a bear market, the model is safely in cash. Otherwise, once the correction is over, the 20EMA will eventually cross up through the 50EMA and generate a new BUY signal. The objective of the Model is to exercise caution when sufficient weakness is shown. Also, the Model signal is an information flag, not an action command, and we need to look more closely at trend and condition.”

“Let's zoom out to a three-year view of SPY. We can see a pretty well defined rising trend channel. Remember, the rising bottoms line defines the trend, and the rising tops line defines the top of the channel. The dotted line defines a channel bottom within the wider channel formed by a line drawn across the November 2013 and October 2014 lows. There is a rising wedge that has resolved downward, as expected, but in the process price also broke down through the first rising trend line, making this a more serious issue. We can also see that price has crowded the top of the channel for nearly two years, but that ended this year when price began moving nearly sideways across the channel and is close to challenging support of the second rising trend line. The chart also displays the primary indicators I use for longer-term analysis. These indicators give us feedback on price (PMO), breadth (ITBM) and volume (ITVM), and they are all below the zero line and have been diverging negatively from price for many months. They are all somewhat oversold, but they still have plenty of room before they reach the bottom of their normal range, about -250. ”

“A final piece of evidence is that the monthly PMO has crossed down through its signal line, which gives us a long-term PMO SELL signal, which hasn't happened since the 2007 market top.”

The author stops short of calling the market top but is simply highlighting the need to take a less aggressive approach and be prepared for what looks like a potential top.

The Bull Case

A few days later I read an article (via Business Insider) entitled, “TOM LEE: I see a 'buy' signal that wins 93% of the time”. He points to several separate market indicators that he says puts the odds of a market rally into the end of the year at 93%. By his estimates, we could see the S&P 500 rise by 9% from here.

Mr. Lee pointed out that the implied volatility term structure has inverted. This happens when the vix spot pricing trades above its three month implied volatility figure. “Excluding recession years, Lee says, this inversion has happened 11 times since 2004 — and in seven of them, the sell-off ended within days. Three of the other inversions saw longer sell-offs during 2010-2011 because of the impeding threat of a US government shutdown. According to Lee, returns after inversions are impressive, with markets rallying an average of 6% (in three months) and 10% (in six months), with 100% and 90% win ratios, respectively.”

He made note that sentiment as a contrarian indicator is overly somber and that in turn can cause the market to turn higher from these levels. “The American Association of Individual Investors' net percentage of bulls minus bears was at -12% on July 2, the second-lowest level since 2013 (the lowest being -13% on June 11). But, as Lee has pointed out before, extremes in this case usually mean the opposite: "Historically, the AAII survey is a contrarian indicator with a very good track record at the extremes," Lee wrote in a note last month.”

When viewing these two indicators together he goes on to say, “Excluding recession years, there have been five times in which the VIX term structure was inverted AND net percentage of bulls minus bears was at or below -12%, as is the case today. “Each of the five precedent periods was associated with an extended rally in the S&P 500," Lee wrote. He added that rare occurrences resulted in rallies averaging 6% (over three months) and 9% (over six months) with a 100% win ratio.”

He says yield spreads are also confirmation that the market is due for an upward move. “In the first six months of this year, the spread between 30-year and 10-year Treasury notes — known as the long-term yield curve — steepened significantly. This is an unusual occurrence six years into an expansion. Looking at the 13 times in which the LT yield curve has steepened in the first half of the year amid positive market gains, markets further gained 85% of the time, with an average gain of 9%.”

Additionally he says the S&P 500, that has been underperforming the German Dax is due for a reversion to the mean. “Germany's DAX is an index of the country's 30 largest companies (think Siemens, BMW, Deutsche Bank, etc.) The DAX is outperforming the S&P 500 year-to-date by 1,500bp — the third-biggest triumph since 1959. But, as Lee also pointed out last month, US stocks are "due for a catch-up trade." Lee says that whenever the S&P has underperformed the DAX by so much, it catches up by rallying through year-end. The historical average gain is 12% with a 100% win ratio, excluding recession years. He sees a strong sign of a better second half of the year for stocks.”

Our Indicators

At the end of our last blog entry, we stated that we were starting to believe in a 2H15 rally. This comes on the heels of interesting data that we are getting from our internal indicators.

Percentage of NYSE stocks trading above their 200 day moving average – When the percentage of stocks trading above their 200 day moving average falls below 35%, it’s usually a sign that a near-term bottom has been put in place for the stock market. During times of economic turmoil this indicator can indeed fall much further (sub 15% is a great buy signal) but as we wrote in our last post, we do not think an economic recession is on the horizon.

AAII Investor Sentiment Survey is exceptionally pessimistic – This is one of the indicators that Mr. Lee pointed to and one that we track as well. As of the last reading, only 27.9% of respondents said they were “bullish” towards the market and 29.2% said they were “bearish. We use a ratio of the two scores to determine a “bull/bear” reading. A bull/bear ratio of 28.5% is an outlier (one standard deviation) and signifies potential market upside. The percentage of respondents that are bullish is also below one standard deviation from the mean and is considered to be positive for the future market direction.

NYSE new high/low momentum indicator is signaling a buy – We use the number of new highs divided into total new highs and lows as a measure of market sentiment. For the S&P 500 this measure is nearly two standard deviations from the mean currently and signals a buy reading. The same can be said for the Nasdaq Composite.

Put-Call ratio is signifying market lows – The CBOE Put-Call ratio hit a high of 1.45 and signifies an extreme reading of market nervousness. Using a z-score to show where it lies on the bell curve, reading we are receiving and indicative of a near-term market rally.

Bottom Line: We remain in the bullish camp for the time being but are keeping a close watch on market sentiment. We understand the market is overvalued on a fundamental basis but as long as the behavioral/sentiment profile holds up, we are still questioning what will spark a correction in the market.

Joseph S. Kalinowski, CFA