For the most part we have spent 2016 on the short side of
the market. On Friday we decided to take off all of our short positions in our
trading account and are waiting for signs of a follow-through of Friday’s rally
to take a long position once again. We were a bit surprised that the market
retained its gains heading into a three day weekend but the market proved
resilient, albeit on low volume. News on the oil front about production
controls has the market in full risk-on mode this morning. Here are a couple of
near term items that lends itself to a rally from here.
Item #1: The
economic picture has improved slightly putting into question the worries of a
U.S. economic recession. From Business
Insider, “Retail sales jumped more
than expected in January, up 0.2%.
Excluding autos and
gas, the advance estimate from the Census Bureau showed that retail sales rose
0.4% compared to December. And, the retail sales control group, which feeds
into GDP calculations, rose 0.6%.”
Consumer sentiment remains relatively stable as well. “Over the last few weeks, concerns had
mounted that the recent market turmoil would soon dampen consumer confidence
and spending.
But consumer sentiment
remains at a relatively elevated level, even after the unexpected drop in the
University of Michigan's index to 90.7. And as TD Securities' David Tulk argued
in a note to clients, it's still too soon to tell whether the sell-off in stocks
will be followed by an economic downturn.
A downturn in stocks
can be a leading indicator of economic activity but doesn't serve as one on a
consistent basis.” (
Business Insider).
This is positive news in the face of deteriorating stock
returns and the negative wealth effects it can have on the consumer. One
possible explanation comes from
Deutsche
Bank's Torsten Sløk. He states (via
Business
Insider),
“Many are worried about
what the hemorrhaging stock market could mean going forward for the overall
economy.
But Deutsche Bank's
Torsten Sløk argues that the negative wealth effect on the economy caused by
investors freaking out about turbulence in the markets shouldn't be too huge
because middle income consumers are feeling good.
In a recent note to
clients Sløk wrote that, generally speaking, an increase in wealth has a
greater impact on consumer behavior than a decline in wealth.
"Given how small
the positive wealth effects have been over the past seven years then it would
be a surprise if the negative wealth effects are big, in particular in a
situation with consumer sentiment for middle income groups rising in January
and at levels higher than in 2005 — 2006," he argued.
"Put differently,
the lack of a slowdown in the broader macro data including consumer sentiment,
the unemployment rate, the quits rate, job openings, hours worked, wage inflation,
and jobless claims [Thursday] morning, suggests that the negative wealth
effects are indeed going to be limited," he continued.”
Additional information from
XE
blog also shows things may not be as bad as feared on the economic front.
They state, “Recent
market and statistical weakness has led to increased discussion of a possible
US recession. In this column, I will
argue that instead of a recession, we’re facing a situation similar to the
mid-1980s, where the economy also experienced slowdown caused by high oil
prices, a strong dollar slowdown and weak oil sector. But there is insufficient weakness – largely
thanks to continued housing market strength and recent wage growth – for a
recession to occur.”
When looking at the quarter over quarter economic growth
figures, “Between 1Q15-4Q15, personal
consumption expenditures (PCEs) fluctuated between .6% and 3.9% Q/Q
growth. Durable goods purchases varied
between 2%-8% growth – an encouraging pace.
And service spending was constant, with numbers seesawing between
2%-2.7%. Investment is where problems
emerge. Non-residential structural
spending contracted in 3 of the last 4 quarters; spending on equipment was weak
in 2Q14 (.3% increase) and contracted in 4Q15.
But residential investment grew strongly in all four quarters. And finally, we have exports, which
contracted in 2 of the last four quarters.
The Q/Q numbers show modest growth, with the weak oil/gas extraction
market and strong dollar hurting growth.”
Using the same metrics and analyzing year over year figures
they write, “Topline PCE growth recorded
levels between 2.6%-3.3% for the last 4 quarters – a decent pace of
growth. Consumer durable goods
expenditures were very strong, vacillating between 5.2% and 7.3%. As with the Q/Q figures, Y/Y business
investment numbers were weak; non-residential structural investment declined in
3 of the last 4 quarters. But
residential spending increased at a solid pace.
And exports declined in the 2H15.
So, like the Q/Q numbers, we again see evidence of industrial and export
weakness.”
When speaking to leading and coincident economic indicators,
“The LEIs have printed either 0 or
negative readings in 4 of the last 7 months while the CEIs have printed between
.1 and .3 (top table). But while the
lower table shows a slowdown in the LEIs 6 month rate of change, the CEIs
increased. Here is the conclusion
reached by the Conference Board’s economists
The Conference Board
LEI for the U.S. declined in the final month of 2015, with its six-month growth
rate decelerating. In addition, the strengths among the leading indicators are
now balanced with the weaknesses. Meanwhile, the CEI has continued rising
slowly, and as a result its six-month growth rate is higher than in the first
half of 2015. Taken together, the current behavior of the composite indexes and
their components suggest that while risks to growth have increased, although
not significantly, the expansion in economic activity should continue at a
moderate pace in the near term.
In theory, LEI
weakness should translate into CEI weakness.
When that doesn’t happen, it is more likely than not that a recession
isn’t likely.
The reason for the
current slowdown is a combination of weak international growth, a strong dollar
and weak oil prices. The economy faced
the exact same set of facts in the mid-1980s.”
Item #2: There
has been heavy shorting of the stock market from hedge funds and at least in
the near term much of the negativity surrounding interest rates, oil prices,
corporate earnings, slowing global economic growth etc. may be reflected in
prices. Again we state that this is a near term phenomenon. We continue to
believe there exists the potential for the market to drop significantly lower
from these levels. That said, any bit of positive news (oil production, Fed
dovishness, additional QE from global central bankers) could spark a near term
rally that could start a short squeeze and higher equity prices.
Citing a story from
ValueWalk,
“Behavior at market lows is always
interesting, and the February 9 notes that $59 billion of net shorts that have
been added in S&P 500 futures over the past 30 trading days. Who has been
engaged in this selling? It is a key alternative investment category, among the
biggest users of futures, who got short recently.
“On our books over the
past two weeks, it has been Hedge Funds that have seen a significant shift
towards short positioning,” the Morgan Stanley report said. “The % of Hedge
Funds that were short S&P 500 futures as of Friday’s close was the greatest
it’s been since the week of September 11, 2015 and, prior to that week, since
the fall of 2011.”
In the relative value
camp, the report noted on Monday’s close, US Long/Short Net Leverage returned
to post-crisis lows. Looking from a different perspective, gross leverage
remains 14-15% above its ‘10/’11 troughs, the report noted.”
“On a short term
basis, Morgan Stanley’s “Pain Monitor,” measuring open interest, it touching a
historic mean reversion point. On a fundamental level, often times when a trend
ends market participants will have exhausted a significant directional capacity
to contribute to price persistence. In many cases this leads to a mean
reversion point.
Looking at the “Pain Monitor”
exposure level mean reversion opportunities appear to exist in other markets,
not just the S&P, setting up some interesting correlation trades.
David Rosenberg seems
to agree. In his latest note to client he states:
One last item to note
which is sentiment (that wonderful contrary indicator at extremes). The
Investor’s Intelligence survey just came out for the past week and the bull
camp retreated to a five-month low of 24.7% from 34%; and the bear share edged
up to 39.2% from 27.9%. So the bull/bear spread widened out to -11.1 from -4.1
which indeed is a step in the right direction for those seeking a near-term
tradeable rally at the very least. This takes out the -10.4 level hit last
summer and not far off the-11.9 reading reached in 2011 that presaged a nice
bounce back at the time as the shorts ran for cover. Remember, the large
positive spread in favor of the bulls (+43.5 in April) touched off this severe
corrective phase. What goes around comes around.
Indeed, the latest Commitment of Traders Report
shows there now to be an eye-popping 46,738 net short S&P 500 contracts on
the Chicago Mercantile Exchange … surging four-fold so far this year to the
highest level since late November, 2011.”
Item #3: The
transportation sector seems to be catching a bid. According to the latest
Cass Freight Index Report,
“The number of freight shipments and the
dollars spent on freight have been in a typical seasonal decline since
September 2015. Our shipment index opened the year just 0.2 percent below last
January, while the expenditures index is down 1.4 percent. The economy grew
much more slowly in the second half of 2015, so January freight shipments are
down 11.6 percent and dollars spent are down 11.5 percent from the June 2015
high. The declines in the fourth quarter and again in January are normal
seasonal trends and are not necessarily signs of further weakening.”
On shipment volumes, “Year
over year, freight shipments were essentially flat from last year, just 0.2
percent lower than last January. Sequentially, January was the fourth month in
a row that the number of freight shipments declined. The Association of
American Railroads (AAR) reported that carloads were down 20.6 percent, while intermodal
loadings fell 11.9 percent over December 2014. The AAR attributed the decline
to soft economic conditions in the U.S. and globally. The continued steep
decline in energy prices hurt the railroads on several fronts in January.
First, it caused a dramatic decline in coal shipments, one of their primary
commodities, as power generating plants continue to shift to less expensive
natural gas. Second, a drop in petroleum and petroleum products shipments as
oil mining came to a virtual standstill in the U.S. And third, there has been a
loss of shipments of materials used in petroleum extraction. Truck tonnage also
eroded in January, but not to the same extent as railroads. Carriers are
reporting that capacity and demand are very well matched right now.”
On freight expenditures, “The
freight payment index fell 1.9 percent in January (from December), and is 1.4
percent below the January figure in 2015. The decrease in January 2016 is much
less than the December to January drops of 5.7 percent in January 2015 and 5.1
percent in January 2014. The decrease can be mainly accounted for by the drop
in the number of shipments and the mix of commodities moved. Generally
speaking, rates were stable in January because available capacity was not a
problem.”
They go on to summarize, “The
Institute of Supply Management’s (ISM) monthly PMI Index Report in January
showed that although the PMI Index remained below the 50 percent
threshold—indicating that manufacturing is contracting—the index rose for the
first time in four months. The 0.4 percent increase is a sign that
manufacturing may be reawakening. The Production Sub-index rose 0.6 percent,
along with a healthy 5.5 percent increase in the New Order Sub-index. If
manufacturing continues to grow—and it should—freight levels will return.
Although factory employment has been hit hard by weak exports, job hires were
up 29,000 in January.
The Labor Department
released figures recently showing another decline in unemployment, which fell
to 4.9 percent. Even better news for the economy is that there was a half a
percentage point gain in average hourly earnings in January. This, coupled with
the growth of wages in the second half of 2015, should increase consumer
spending, giving the economy another boost. Wages have grown more in the last
six months than in any other time since the recovery began over six years ago.
The number of new jobs created in January was much lower than in December, but
much of this is due to the hiring of seasonal workers.”
It’s not quite a ringing endorsement on all things moving
but certainly not gloom and doom.
In fact the transportation industry could be on the verge of
a major bottom as pointed out in
See
It Market. They write,
“To give you
an idea, the Dow Jones Transports is down over 20 percent in the last 12
months, having fallen over 30 percent from the late 2014 highs to January 2016
lows.
Below is a chart
looking at the Dow Jones Transportation Average/S&P 500 ratio over the past
10 years. The ratio shows that the Dow Jones Transports has been much weaker
than other stock market averages over the last year.”
“After hitting channel
resistance at point (1) a year ago, the Dow Jones Transports declined nearly
declined as hard as it did during the 2009 collapse. This decline took the
Transports relative strength down to channel support at point (2), where a
small rally has now taken place off the January lows. This could simply be a
bounce, but it is reflecting some relative strength against the broader
markets… for the first time in a year.
Below looks at the Dow
Jones Transports Index As you can
plainly see, it has been a painful decline.
The decline over the
past year has taken the Dow Jones Transports from channel resistance back down
to its rising trend support at point (1). This major support level also happens
to be the 38 percent Fibonacci retracement level as well (of the 2009 lows/2015
highs). As the Dow Transports Average was hitting this confluence of support a
few weeks ago, it also created a reversal candlestick at point (1).”
A rebound in the transportation sector could act as
positive reinforcement for the greater markets that a recession isn’t likely
and this pullback should be considered a correction. At the very least it may
provide a brief short term tailwind for the markets.
Item #4: The
percent of companies in the S&P 500 that are in a bullish point and figure
formation are extremely low and are signifying the possibility of a near term bounce. Currently only 29.8% of the
companies in the S&P 500 are in bullish point and figure formations (and
this is after the rally on Friday, on Thursday the figure was 27.6%). Typically
when this figure falls below 30% it represents a near term bottom in the
market.
We have been tracking this data since the early 1990’s and
there have been a few occasions when this metric was this low. The good news is
that this is a strong indication that a tradable bottom is available in the
near term. The bad news is that once this signal is initially met, there is a
pattern of more to come and the market has usually gone lower from that point. In
a word this metric becomes active in pinpointing short term rallies in a down
trending market. It gave us several tradable rallies starting in late 4Q 1998,
3Q 2001, 2Q 2002 before finally bottoming in 1Q 2003. It also registered in 1Q
2008 for a tradable rally then giving us another reading in 1Q 2009. As one can
see from the start of the first tradable bounce to that last the market got
destroyed both times. Only in 3Q 2011 did the initial reading pick the bottom.
In 3Q 2015 we got our first reading for a tradable rally and
now this past week we got a reading for 1Q16. This may be the final reading in
this correction but given the technical damage to the market it’s hard to
imagine the lows have been set.
Item #5: There
appears to be bullish divergences all over the daily chart for the S&P 500.
All the oscillators that we track are oversold and exhibiting a bullish
divergence. The MACD, percent in bullish point and figure formation, percent
of companies above their 50 and 200 day moving average and percent new hi/lo all exhibiting
a bullish divergence. This adds to the trading thesis that we are expecting a
near term bounce in the market. On the weekly chart all measures are oversold.
We believe that if the rally from the daily metrics are strong enough to spark
and improvement in the weekly metrics, we could see a sharp rally into the end
of 1Q16 and into 2Q16.
Item #6: Oil
prices have stabilized. This news is breaking as I write this analysis. According
to a note I just received from
Seeking
Alpha,
Russia, Saudi Arabia agree to
freeze oil output.
They summarize:
“Top oil officials
from Russia, Saudi Arabia and several key OPEC members have agreed to freeze
crude output at January levels at a meeting in the Qatari capital Doha,
targeting a supply glut that's sent prices to 13-year-lows.
According the
International Energy Agency, Saudi Arabia produced 10.2M bpd last month, below
its most recent peak of 10.5M bpd set in June 2015. Russia produced nearly
10.9M bpd in the same month, a post-Soviet record.
Oil soared almost 6%
ahead of the meeting - on expectations of a more weighty announcement - but
pared gains following the news. Crude futures +1% to $29.72/bbl.”
We think this could prove a nice tail wind for the market in
the near term as the correlation between oil prices and equity prices have been
higher than normal recently. The next chart found in an article entitled
Oil Is the Cheap Date From Hell found in
BloombergBusiness
shows that correlation.
The article states, “History
is a useful guide. So far this year, the S&P 500 is moving in closer tandem
with West Texas Intermediate, the benchmark U.S. crude oil, than in any year
since 2000 except for 2010. The reasons for the high correlation in 2010 were
similar: abundant oil supplies and fears about global growth. Interestingly,
around the second week of February 2010, the mood turned. The correlation
continued, but with oil and stocks both rising instead of falling.”
Given the large shorting activity around oil prices we could
see a short squeeze in oil that will benefit stock prices should the
relationship hold.
True U.S. oil production has leveled off and rig counts have
been dropping heavily. The question arises as to OPEC’s ability to adhere to
production cuts. Many experts don’t think so.
From Business
Insider, “Most recently, on Thursday,
The Wall Street Journal's OPEC correspondent Summer Said tweeted: "OPEC is
ready to cooperate on a cut, but current prices are already forcing non-opec
producers to at least cap output, says UAE Energy min."
But the Kingdom might
not be ready to fold just yet.
"Possible ongoing
talks on coordinated OPEC and non-OPEC crude oil production cuts are unlikely
to be successful in the near-term, in our view," argued BAML's MENA
economist, Jean-Michel Saliba, in a recent note to clients.
"Saudi Arabia
appears to be continuing in the meantime to position its energy and fiscal
policies for a lower for longer oil price environment, if need be, as suggested
by the possible flotation of Saudi Aramco or parts thereof."
And Saliba writes that
if the oil behemoth does go public, it "would be a landmark event."
"We believe that
a potential IPO of Saudi Aramco ... could assuage key macro concerns regarding
unsustainable debt accumulation and Fx reserves drawdown," he wrote.
"It also would confirm the economic reform credentials of the
current Saudi administration and its financial preparedness for a potentially
prolonged period of low prices, in our view."
Saliba also argues
that the conservative oil-price assumption in the Saudi's 2016 budget also
suggests that the Kingdom is "unlikely to capitulate on its energy policy
as the adjustment is being carried on the fiscal front."”
They go on to state, “Moreover,
he writes that it may not even be that compelling for the Saudis to cut in the
short/medium term (emphasis ours):
We have suggested
that, in the short-term, a unilateral cut from Saudi Arabia appears a
marginally revenue-positive move. This could
leave it indifferent between a unilateral cut and no cut, partly as other oil
producers would free-ride and encroach on Saudi’s market share.
This
"indifference" arises because a 1mn bpd cut would increase the fiscal
breakeven oil price by US$10/bbl and, concurrently, broad elasticity measures
would suggest a US$10-12/bbl move upwards in oil prices. However, the elevated
starting level for the fiscal breakeven oil price restricts such a policy,
given the budgetary flexibility required of a swing oil producer. In the medium-term, unilateral cuts would
likely be unambiguously revenue-negative as both the supply and demand curves
would respond to higher oil prices.”
“And, finally, another
interesting idea to consider is what the "signaling impact" of such a
coordinated cut could be — and how the Saudis may interpret this. "Headlines
on joint cut discussions have already managed to talk up oil prices.
Elasticities may likely be non-linear, suggesting a more marked impact on
prices from output cuts at low oil prices," he writes.
"This suggests
difficulty to control the extent of the oil price rebound, which could be used
by non-OPEC producers as a lifeline to initiate hedges or obtain additional
financing," he adds.
In any case,
ultimately, Saliba believes that the Saudis are "best placed" to sit
through the lower oil prices if there won't be coordinated policy action.”
We closed our short positions and booked profits for the
start of 2016. While we still believe the longer term trend for the market is
lower we understand that there will be reflex rallies on the way down. We
believe the market has washed out in the near term and lends itself to a rally
that could take the market higher for the remainder of 1Q16 and into 2Q16
before resuming its downward trajectory.
We cite “less negative” economic figures, excessive short
positions in stocks and oil, improving price action in the transportation
sector, excessive negativity in the S&P percent of bullish P&F
formation, bullish divergences on the daily SPX chart and oversold conditions
on the weekly SPX chart and oil stabilization.
We didn’t mention easing monetary policy as Mario Draghi
spoke this weekend with dovish comments and we expect the Fed to soften their
language over time as well.
Bottom Line: We are
going aggressively long here for the first time since November of last year. We
think there could be a powerful rally from these levels but continue to believe
the market lows for the year have not been set. We are looking for a strong
rally to end February and March. Come the second and third quarter of the year
we could see weakness again and we believe this is going to be the summer to
short the market. By the third and fourth quarter hopefully this downward trend
will bottom.
Joseph S. Kalinowski, CFA
Email: joe@squaredconcept.com
Twitter: @jskalinowski
Facebook: https://www.facebook.com/JoeKalinowskiCFA/
Blog: http://squaredconcept.blogspot.com/
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