Saturday, June 25, 2016

BREXIT Inspired Equity Pullback: The World Is Not Coming To An End

Much is being written regarding the impact of the United Kingdom's exit from the European Union and all the conclusions lead to uncertainty. It is the uncertainty equity markets do not handle well, thus, the sell off on Friday. One conclusion I believe is certain is the world will not come to an end and business will continue to be conducted between EU and non-EU countries. This is a wakeup call for the EU and its seemingly unending promulgation of rules and regulations that seem to favor some EU member countries over others. On paper the formation of the EU seemed like a good idea; however, a monetary union without a fiscal union has led to a lack of spending discipline by some countries. And, no real spending discipline is a symptom not only of EU countries, but with non-EU countries as well. The United States can be included in the 'no discipline' crowd too. Our firm will have more commentary on the Brexit outcome later.

The damage done to global equity markets on Friday is pretty clear. The Nikkei was down 7.9%, S&P 500 Index down 3.6%, the Dow down 3.4%, the French CAC Index down 8.0%, Spain's IBEX 35 Index down 12.35% and the UK's FTSE 100 Index was down 3.2%. The unknown is what additional weakness can be expected in global equity markets over the next weeks and months ahead. In earlier blog articles, I have noted past crisis events and their duration and time to recover. Below is a chart from a June 28, 2015 post.

From The Blog of HORAN Capital Advisors

Some of the crisis influenced market declines bottomed after one day while other declines took place over a longer period of time. The average decline in terms of days was six with an average return of -5.3%.

The sentiment technicals for the S&P 500 Index are indicating fear is elevated. Historically, when the fear measure like the VIX is elevated or the equity put/call ratio is above one, these levels have coincided with near market bottoms. The first chart below shows the CBOE Equity Put/Call ratio spiked above 1.0 on Friday.

The VIX futures went into backwardation on Friday as well. VIX backwardation refers to the situation when the near-term VIX futures are more expensive than longer-term 3-month VIX futures (VXV). This is an indication traders expect volatility in the future to be lower than it is now. Historically, when this occurs, short term market rallies tend to result from this technical event.

The other sentiment measure that is indicative of an oversold market is the ratio of the VIX to the 10-year U.S. Treasury yield. The low level of the denominator of this ratio, the 10-year Treasury yield, is indicative of a slow growth economic environment and investors' propensity for risk off assets; hence, driving the yield lower. The numerator, the VIX, is elevated thus, an indication of investors' fear of the equity markets.

An expected certainty in this Brexit inspired uncertainty is the fact the markets will continue to be volatile. Of importance is whether or not this event pushes Europe into a recession and drags the U.S. into one along with it. What makes this a heightened issue is the slow, bump along growth, of the U.S. economy and the slow economic growth globally. The added uncertainty is whether or not Brexit leads to additional EU countries taking steps like the UK's and then the ultimate breakup of the EU. The world is not coming to an end and this Brexit induced equity market pullback will likely provide investors with a buying opportunity in equities that have been unduly punished.

Saturday, June 11, 2016

Simply A Technical Review Of The S&P 500 Index

Quite a bit of discussion circulated after the market closed on Friday surrounding the S&P 500 Index and the resulting weekly chart candle that formed for the week. As the below candle stick chart clearly shows, a shooting star formed out of the weekly market action. One factor making this formation of interest to technical market traders is it occurrence subsequent to a strong market uptrend and the previous weekly candle was an indication of pretty strong uptrend. So, this shooting star is viewed as a bearish signal since sentiment has changed so dramatically. Downside market follow through is needed though in order to confirm a potential market reversal.

A couple of factors that may counter this bearish formation is the fact volume on down weeks has been declining. Equally important is the fact volume on up weeks has been declining as well.

From a positive standpoint, the chart pattern on a 30 minute chart shows buyers came in during the last hour and a half of trading. This resulted in the market bouncing off the 200 period moving average. The market has a tendency to fill gaps created in chart patterns and a gap above formed with Friday's lower open.

From an investor sentiment perspective, the individual investor remains skeptical of the market's rebound from the February low based on AAII's Sentiment Survey. The 8-week moving average of bullish sentiment is at a level coincident with a market bottom.

And lastly, reviewing the bull/bear spread that is reported with AAII's Sentiment Survey, the below chart shows the 8-week moving average of the spread compared to the S&P 500 Index. The level of this average of the bull/bear spread is also at levels associated with a market that is nearing a turn to the upside.

The above analysis is all based on technicals and the market certainly needs to digest other issues, like a Fed rate hike and the BREXIT vote on the 23rd of this month. From a sentiment perspective, and given the contrarian nature of this measure, investors may be too heavily tilted to bearishness. On the other hand, the technicals are giving off mixed signals and combined, these are likely to lead to continued market volatility over the next several weeks.

Saturday, June 04, 2016

The Consumer Is In Good Financial Shape

With the weak nonfarm payroll report on Friday, heightened concern arose about the pace of economic growth or lack thereof. Pundits and market indicators believe a Fed rate increase in June is off the table. A weak payroll report is an indicator of a weakening economy and certainly the trend in nonfarm payrolls has been a declining one. This declining trend has been in place over several months, +233,000 in February, +186,000 in March, +123,000 in April and +38,000 in May. Determining what this means as investors look ahead for the balance of the year is important. I believe Scott Grannis provides good insight on Friday's report and implications for the months ahead in his post, No Improvement in the Jobs Market.

The weak payroll report comes on the back of some weakness in the manufacturing data. For example, in late May the Durable Goods report saw core capital goods orders decline a .8%. However, there are some bright spots in a few of the manufacturing reports. For example, Econoday noted, "There are...solid points of strength in the report including 0.6 percent gains for both total shipments and total unfilled orders. The gain for unfilled orders is the largest since July 2014. Another plus is a 0.2 percent decline in inventories which pulls down the inventory-to-shipments ratio to a leaner 1.65 from 1.67. A graph of the unfilled orders chart is below. A small positive is the fact unfilled orders have increased in three of the last four months.

The consumer accounts for about 70% of economic activity (GDP) and their health is critical to economic activity. In this regard, there are many positives with consumers overall.
  • University of Michigan Consumer Sentiment: The May sentiment survey showed an increase of 5.7 points compared to the April report. The May report noted, "consumers became more optimistic about their financial prospects and anticipated a somewhat lower inflation rate in the years ahead. Positive views toward vehicle and home sales also posted gains in May largely due to low interest rates."
  • Retail Sales: The positive consumer sentiment report also carries over into retail sales. The favorable report was spread across many of the categories, autos up 3.2%, non-store retailers (e-commerce) up 2.% for the month and up 10.2% versus April last year. Overall for April, retail sales were up 1.3% and up 3.0% on a year over year basis. The next retail sales report comes in about ten days. This growth in retail sales is evident in the below chart. A cautionary observation is the rise in both the retail inventory to sales ratio and the manufactures inventory to sales ratio. On the positive side, the above noted durable goods report indicated inventory of manufactured durable goods is down in nine of the last ten months which has pulled down the inventory to shipments ratio.

A final question revolves around how are consumers financing this spending. Clearly, the below chart shows borrowing has been an important source of funds.

This increase in consumer credit outstanding certainly raises the question of the ability of these consumers to repay their debts. Positively, debt payments as a percentage of disposable income remain at levels seen in the early 1980s and down from the 2004 high of 13.2%.

Manufacturing sector growth has slowed to a snails pace as well. In our view this has become the norm in this subpar GDP growth economy. As the below chart shows, the Composite PMI is near contraction, not unlike the economy has experienced a number of times since the end of the financial crisis.

Source: TalkMarkets

In summary, Friday's payroll report probably puts the Fed on hold for a rate increase this month. Reading the Grannis article mentioned in the opening paragraph places Friday's report in proper perspective. Data suggests the consumer is on pretty sound footing and they are responsible for more than two thirds of economic activity. Given the consumer is a fairly good shape, we believe this factor provides support for continued economic growth, albeit subpar growth. On top of all of this is the fact consumers, businesses and investors will continue to face election year rhetoric that most likely leads to continued market volatility. However, a recession does not seem in the cards at the moment. 

Thursday, June 02, 2016

Is It Right To Be Bullish Near A Record Market High?

One outcome that comes from writing periodic content on our blog is we are held accountable for our various points of view whether they are right or wrong. No investor is going to be correct 100% of the time; however, being right more often than wrong enhances ones chance of better returns over the long run. So, as the S&P 500 Index is only 1.2% below its all time record closing high, being bullish now feels more difficult than being bullish this past February, after the market had declined nearly 12% to begin the year.

On February 27th of this year I published a post, Bearish Sentiment And Positive Uptick In Economic Reports May Translate To Higher Equity Prices, where I discussed reasons why higher equity prices were a most likely outcome. At that time individual and institutional sentiment measures were deeply bearish. In fact, an RBS economist said to sell everything in mid January after a large part of the early year equity decline already occurred. For our clients, we took advantage of the February equity market pullback to reposition some stock holdings in our client accounts and purchase companies we had an eye on, but believed a purchase at a lower price/valuation would come along and February provided that opportunity.

Today the market is near a record high, individual investor sentiment remains low, the U.S. economy is growing at a snails pace (less than 1.0%), Britain is contemplating exiting the Euro, debt issues in Greece remain unresolved, some retailers are losing out to online retail (Sports Authority files bankruptcy). Well you get the picture and I have only touched on a few issues facing economies around the world, but there does not seem to be a lack of bad news and anyone of those might be reason enough to sell equities, but we aren't at the moment.

Being bullish after a double digit market decline seems a lot easier than being bullish near market tops. Knowing the market does not move up or down in a straight line, are there factors we see that would support higher equity prices? In the intermediate and long run, we believe fundamental company and economic factors are key drivers of stock price returns.

From a fundamental company perspective, a few weeks ago we wrote about the potential for improved earnings, and a resumption of growth, as the year progresses. As the updated chart below shows, an improved earnings picture is something that would favor higher equity prices if the growth materializes. Reading the earlier post provides our point of view on why this seems a likely outcome.

In the short run though, technical market factors can impact equity price movements. A part of what drives this is the growth in computerized trading and the algorithms used by the trading programs. Technical chart patterns enable the algorithms to trade in and out of equities, for example, based on price targets generated by chart patterns.

As the below technical chart of the S&P 500 Index shows, the chart pattern for this index has traced out a cup and handle chart pattern. The pattern has triggered as the index has moved through the line representing the cup top. The measured move target for the S&P 500 Index based on this pattern is 2,340.04.  If the target price is realized, this is a mid-teens price increase for the Index. As coincidence would have it, the expected earnings growth rate approaches double digits as the year progresses. Of course, not every chart pattern that triggers will see follow through to the target; however, this is a favorable set up at a time the S&P 500 Index is near a market high.

Lastly, looking at individual investor bullish sentiment, it currently remains at a low level, i.e., 30.2%, and remains below the long term average level of 38.5%. In the weekly Sentiment Survey report released today, bullish sentiment did show a rather large increase of 12.4 percentage points.

Source: AAII

Are there issues ahead that will result in an equity market pullback? Most likely. However, with the prospects of an improved earnings picture and a positive technical set up for the market, the S&P 500 Index may be set to finally breakaway to the upside and out of its nearly two year trading range. Leaning bullish at the moment, and near a market high, seems reasonable given the favorable technical and fundamental picture.

Monday, May 30, 2016

An Allocation To International Small/Mid Cap Equities

One aspect that has faced investors over the past five years is the fact diversification has detracted from a mostly large cap U.S. equity allocation. Investments in high yield bonds and emerging markets generated negative returns, while investments in the NASDAQ and S&P 500 Composites resulted in double digit annualized returns over the most recent five year period.

Thursday, May 26, 2016

Bullish Investor Sentiment Lower Than Level Reached In 2009

The American Association of Individual Investors reported another decline in bullish sentiment this morning. Bullish sentiment was reported at 17.8% and comes in below the level reached at the depths of the financial crisis in 2009. The lowest reading in 2009 was 18.9% and occurred in early March of that year. A number of market technical indicators have turned positive as we noted in a few posts over the past several days. Now with bullish sentiment coming in at an extremely low level, it is not a surprise the market has bounced higher over the course of the past week. Investors are reminded this is a contrarian indicator and is most predictive at its extremes.

Wednesday, May 25, 2016

Dow Jones Industrial Average Celebrates Its 120th Year

On May 26th the Dow Jones Industrial Average (DJIA) will celebrate its 120th year. In honor of this feat, S&P Dow Jones Indices published a white paper containing a number of facts and figures around the Index.  For example, the best trading day of the week for the DJIA is actually Saturday so maybe we should bring back Saturday trading. From 1887 to 1952 stocks were traded on the NYSE from 10:00am to noon.

And for all the 'sell in May' hype, at least for the DJIA Index, July and August are two of the three best performing months of the year. In fact, the summer rally tends to begin accelerating in June. Simply avoiding the month of September, the largest draw-down month, is maybe what investors should consider if they are true believers in the 'sell in May' mantra.

The entire white paper is an interesting and fact-filled read. The action over the last few days make it seem a possibility the nearly two year sideways trading pattern we are stuck in is coming to an end. If so, just maybe it won't be such a long hot summer and investors will be rewarded with average returns generally achieved by the market in the June, July and August months.

Tuesday, May 24, 2016

Bulls Attempting To Take Control On Positive Technicals

The market is in a seasonally weak period, i.e., all the sell in May mantra, and this has created a number of bearish technical setups for the S&P 500 Index. I am not showing all of them; however, the bulls are making an effort to kill off the head and shoulder top pattern (dashed lines). This market action is creating two potential bull flag breakouts. The breakout is also resulting in the S&P 500 Index to trade above its 50 day moving average. Importantly, the larger bull flag pattern has occurred on a strong upside move off of the February low. The potential bull flag breakout has occurred on lower selling volume as well. Lastly, the money flow index (MFI) and stochastic indicator are showing favorable bullish indications.

As we noted in our post at the end of last week,these positive technicals seem to be occurring at a time fundamental headwinds seem to be easing.

Saturday, May 21, 2016

A Mismatch Between Investor Sentiment And Allocation Surveys

On a monthly basis the American Association of Individual Investors surveys its members on the asset allocation of their members investment holdings. In the April survey, on average, its members noted their equity exposure equaled about 64%, above the average of 60%. The bond allocation was equal to the long term average, while cash came in below average. What is interesting about these stated allocation responses is the AAII Sentiment Survey notes a near extreme low on individual investor bullish sentiment. In the Sentiment Survey report released this week, bullish sentiment was reported at 19.3%, which is far below the longer term average of 38.5%.

Recent mutual fund and ETF flow reports have noted the continued outflow in equity investments. Lipper's report for the past week notes:
  • "For the week equity exchange-traded fund (ETF) authorized participants pulled $1.7 billion net from ETFs. They added $942 million net to SPDR S&P 500 (SPY) while removing $1.2 billion from iShares MSCI Emerging Markets (EEM) and $1.9 billion from iShares Russell 2000 (IWM). Equity mutual fund investors pulled $2.2 billion net from their funds and brought the year-to-date equity mutual fund net outflows to $30.4 billion."
  • "Taxable bond mutual funds collected $2.1 billion of net inflows, of which high-yield mutual funds saw net inflows of $203 million and high-yield ETFs took in $931 million. Bond ETFs gathered $2.8 billion of net inflows. The week’s biggest individual bond ETF net inflows belonged to iShares iBoxx $HY Corporate (HYG, +$937 million)."
  • "Municipal bond mutual fund investors added another $1.0 billion net this past week, for the first consecutive billion-dollar-week streak since January 2013. Money market funds saw net inflows of $10.7 billion for the week. Institutions added a net $8.5 billion, while retail added $2.2 billion."
In spite of the lack of investor bullish sentiment and stated equity allocations that are higher than average, flow data and sentiment reports might be a better gauge of overall sentiment than looking at investor allocation responses.

Friday, May 20, 2016

Equity Market Headwinds Positioned To Subside

One thing investors in equities know is the market has essentially traded sideways for nearly two years. During this two year period, this sideways chop has included sharp pullbacks, one in late 2014, two in 2015 and the latest in February of this year. For long term investors this can be disconcerting for sure, so what headwinds are influencing the equity markets and will they subside any time soon?

For the most part no one factor contributes to the market's ups and downs and I will not touch on all the potential influences, for example, the high level of debt being issued by the public sector, pension under-funding, the presidential election in the U.S., etc. At top of mind though are the following:

The oversupply of oil and the downward pressure it has placed on prices (until recently) has had a negative impact not only on the energy sector, but across other segments of the economy (industrial companies) that sell into the energy space. The energy weakness resulted in a contraction in earnings for companies in these segments. However, since oil price lows reached in February, crude prices are up over 80%. Whether this is sustainable is questionable, but, with higher crude prices, companies in the energy sector, and those that sell into the space, are likely to see better earnings versus last year.

This leads to possibly the largest factor facing the market: earnings. As the below chart clearly details, double digit earnings growth in early 2014 turned into an earnings contraction. Combining the four quarters of 2015, the earnings for the S&P 500 Index were essentially flat. This contributed to a flat equity return for the S&P 500 Index for calendar year 2015. Since stock prices have a tendency to follow earnings over time, the trough in earnings in Q1 2016 may give way to earnings 'growth' into Q4 2016. One then asks, how is this growth possible. Two factors are occurring that may contribute to EPS growth from here.

One, the US Dollar strength that took place from mid 2014 and into 2015 has turned into weakness over the last 12 months. The result is multinational companies should experience less of a headwind from translating non US earnings back to the US Dollar.

Secondly, as noted earlier, the increase in oil prices is anticipated to have a positive impact on S&P 500 earnings. The below table shows quarterly operating earnings by sector for the S&P 500 Index. Evident from the table is the favorable swing in earnings for both the energy and materials sectors and the positive impact on expected earnings growth for the index.

Lastly, the Fed and the future direction of interest rates is impacting market sentiment. With the release of Fed minutes earlier this week, it appears a June rate hike is back on the table. The Fed did move rates higher last December and multiple hikes were expected in 2016. It is looking more likely that one, two at most, rate hikes may occur this year, all else being equal. This move higher in short rates is causing the yield curve to flatten, which could lead to an inverted yield curve (short term rates higher than long term rates.) An inverted curve does not always translate into a recession. However, the interest rate curve has been inverted when the onset of a recession takes place. As the above chart shows though, the curve is far from inverted at the moment.

One result coming out of a Fed that is increasing interest rates is a slowdown in economic growth. Historically though, the initial moves in rate increases by the  Fed is pursued to get rates back to a more normal level. As a result when interest rates are increased from a level below 5% stocks tend to rise. In short, below the 5% level there is a positive correlation between interest rates and stocks.

With investor bullish sentiment at an extremely low level, an expectation of an improving earnings picture and a market that has traded sideways for nearly two years, subsiding headwinds could certainly translate into a positive equity environment in the second half of this year.