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.
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
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