US Treasuries Oversold; US Equities Overbought

November 28, 2016

So now after several weeks of bouncing, the S&P500 has really risen to the upper limits of what’s normal for such a short period of time—last week, the large cap index again rose, this time about 1.4%. Volume was very light, but that was mainly due to the holiday shortened week (Thanksgiving). And volatility in equities fell back some more, but not quite down to the doldrums reached over the summer months.

US macro news was once again mixed. The week got off to a disappointing start with the Chicago Fed National Activity Index logging another negative print. On the other hand, the Richmond Fed manufacturing survey and the existing home sales report both exceeded consensus estimates. Durable goods orders also beat expectations. But the FHFA house price index missed. So did new home sales. International trade was a disaster….the big miss will negatively impact the next US GDP report. And PMI flash services also missed. In these last few months, nothing—as usual—has changed for the US economy, which still, fully seven years after coming out of the Great Recession, has never achieved robust growth, growth that would have reversed the disturbing trend in the labor force participation rate which captures all the discouraged workers who are not counted in headline unemployment numbers because they’ve simply given up looking for jobs.

Since the post-election bounce began, several key developments have occurred in the financial marketplace. The USD has soared; while it was already creeping higher in the weeks and months before the election, it really took off after Trump was elected. Next, we we’ve discussed here over the last several weeks, US equity prices have soared. Given that volumes are not huge and given that the dispersion is high (both new highs and new lows are rising), this looks more like a blow-off top than the beginning of a serious move higher and the resumption of a multi-month bull market. Finally, US Treasury prices, the day after the US election results were announced, made a huge move—-lower. This in turn, has driven interest rates much higher.

So where does this leave us? Simple—-US equity prices are extremely overbought (on multiple technical measures) and at the same time US Treasury prices are extremely oversold (using similar technical measures). As a result, anyone who buys US equities now (or sell US Treasuries) will be taking a huge risk that a reversal—-even if it’s short-lived—-will hurt them. On the other hand, making the reverse trade (buying Treasuries and selling US equities) looks like a much safer bet.

US Equity Bounce Continues

November 21, 2016

After the prior week’s massive 3.8% bounce in the S&P500, last week the large cap index rose another 0.8%. Volume this time was much lighter, and volatility only dipped slightly—mostly because it had already fallen back by a huge amount the prior week.

In macro news, retail sales, both headline and ex-autos, beat expectations; so did the Empire State Manufacturing Survey. Unfortunately, business inventories missed. So did industrial production. Inflation—both consumer and producer—seems to be contained, with most of the numbers coming in at or below expectations. The other misses were the Philly Fed Business Outlook and the Kansas City Fed Manufacturing Survey. On the bright side, housing starts and initial jobless claims were both better than expected.

So the technical picture for the S&P500 is still consistent—the bounce that began strongly two weeks ago continued last week, but it’s beginning to lose steam. At the same time, because of the huge size of the two-week bounce, the S&P500 finds itself immediately in very overbought territory…..well above the 50 day moving average and hugging the upper Bollinger band. So suddenly, the S&P500 looks like it’s poised for a pullback, at least in the short term.

Meanwhile, on a valuation basis, the S&P500 is pushing up against 100 year extremes in terms of the median Price to Earnings ratio, Price to Sales ratio, and Price to Book ratio. And a minor pullback will not even come close to correcting this extreme condition. What would? A drop of at least 50% would only bring the S&P500 back in line with 100 year averages….in these same ratios.  To become as undervalued… it is overvalued today…..the S&P500 would have to fall closer to 60-75%. While this sounds absurd, we must not forget that almost all bubbles that burst end up falling by this type of percentage. In fact, many prior bubble markets have collapsed by falling more well more than 75%. Will this time be different?

And Here Comes the Bounce!

November 14, 2016

After falling for several weeks in a row, the S&P500 roared back with a 3.8% bounce last week……on the heels of a surprise win by Donald Trump in the US presidential election. Volume was moderate, and volatility—while spiking during the actual election night—dropped way back down by the end of the week. This drop goes hand in hand with the large bounce in US equity prices.

In US economic news, the wholesale trade missed expectations. Initial jobless claims came in a bit better than expected, and consumer sentiment also beat expectations. So not much in the way of economic reports. Instead, the dominant story of the week was the Donald Trump victory and the impact on financial markets. While the initial reaction to US equities was negative (the futures markets plunged in the hours after the election results became clear), stocks not only recoupled all initial losses, but the went on to roar higher. In fact, by the end of the week, the Dow Jones Industrial average set a new high. But that was pretty much it for asset classes doing well. Almost all other major asset classes dropped, and in many cases, dropped hard. Commodities (oil for example) plunged. US corporate bond prices (especially high yield) dropped notably. US Treasury prices plunged….sending yields up to 2016 highs. Emerging market bonds also plunged. So just about the only asset class that did well….so far….was US stocks.

And technically, this bounce in US equity prices was completely not unexpected. Once again, as noted here only last week:

But more importantly—what’s next? Well the most likely reaction to almost ten straight days of consecutive selling (a record that dates back to 1980!), is some sort of short-term bounce. Precisely because of the long streak of losing days, a bounce becomes a much more likely outcome in the next several days. Why? Because technically, the S&P is oversold on the daily charts, and a reversal would be perfectly normal to predict as the expected outcome over not only the next several days, but even over the next week or two.

And this is exactly what happened.

The main concern about the duration of this bounce is the rising US Treasury yields. As of last Friday, the yield on the US 10 year note reached 2.15%…..which is just a bit higher than the yield on the S&P500 itself. This means that many investors who were looking to the large cap US stock market for a reasonably safe return will now suddenly have reservations—why should they earn a lower dividend in riskier US stocks than they can earn in less risky US Treasuries?  Good question. And history supports this concern—almost all large drops in US stock markets were preceded by rising interest rates. In other words, when all other major asset classes are suffering, and US interest rates are rising substantially, it’s going to be very difficult for US stock prices not only to continue rising much further, but to even hold the gains they’ve recently achieved.

S&P 500 Sliding….Again

November 7, 2016

The S&P 500 continued eroding last week, but this time by a more meaningful 2% by Friday’s close. Volume inched higher; this meant that conviction in the selling was growing. And volatility also spiked….a lot….which meant that investors and traders were buying tons of insurance to protect themselves against even further losses. The VIX index jumped well above 20, after spending most of the last two months in the mid to low teens.

It was a busy week for US economic reports. On Monday, we learned that the Chicago PMI result came in far below expectations. Personal income also missed; at the same time, personal spending only met expectations. Construction spending missed. ADP employment missed. Initial jobless claims were worse than expected. ISM services also missed. On the positive side, ISM manufacturing beat expectations. Productivity came in stronger than expected. And in international trade, the US deficit was still bad, but not quite as bad as predicted. The big number of the week was payrolls, and it missed. Not by a lot, but it was still a miss. Headline unemployment was unchanged, as predicted……and so was the average workweek. Average hourly earnings were slightly better than expected. And unfortunately, the labor force participation rate went the wrong way—it dropped, meaning that a huge number of people left the workforce mainly due to poor employment prospects.

While we often make claims about the overall valuation of the US equity markets (they’re overvalued!), we rarely make claims about short-term timing of future price movement. Last week was one of those times, when we wrote:

The short-term topping pattern that began to take shape at the end of the summer has only been reinforced by last week’s modest loss in the S&P500. This topping pattern is now clearly visible not only on the daily charts, but also on the more important weekly charts. As valuations (based on price-to-earnings, price-to-sales, and price-to-normalized earnings) cling to the extremely high end of long-term historical ranges, the signals coming out of technical analysis become more important because they often provide some of the earliest warnings that prices are headed for a fall. And the signals coming from even the most basic interpretation of the price and momentum indicators is that the S&P500 is poised for a more meaningful retreat.

And last week’s 2% loss validates this short-term call.

But more importantly—what’s next? Well the most likely reaction to almost ten straight days of consecutive selling (a record that dates back to 1980!), is some sort of short-term bounce. Precisely because of the long streak of losing days, a bounce becomes a much more likely outcome in the next several days. Why? Because technically, the S&P is oversold on the daily charts, and a reversal would be perfectly normal to predict as the expected outcome over not only the next several days, but even over the next week or two.