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

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