Mini-Panic in US Equities

May 22, 2017

The S&P500 lost 0.38% last week on slightly higher volume. Volatility, as measured by the VIX index, closed higher on the week.

US macro news flow was light. The Empire State manufacturing index missed expectations—badly, by falling when it was projected to rise. Housing starts also missed. On the other hand, the housing market index, industrial production and the Philly Fed survey all beat consensus expectations. And initial jobless claims continued to hover near multi-decade lows.

The technical picture got uglier last week, not so much because of the modest weekly drop, but more because of the one-day panic sell off that approached two percent. While two percent, on the surface, shouldn’t be such a big deal, it did become a big deal last week because the S&P500 hadn’t had such a large drop in many months. In other words, investors had grown accustomed to unusually minor day-to-day variations in the S&P, so when a slightly larger sell-off occurred, a lot of investors got caught off guard.

More importantly, many investors got re-acquainted with risk, specifically risk to the downside in US equity prices.

With the big one-day sell-off (and despite the fact that a great deal of the one-day loss had been recouped by week’s end), many technical indicators suddenly grew more bearish. Most momentum indicators got pushed downward, and if they were already pointing down, they became even more bearish. Also, the 50 day moving average was not only broken, but the average itself stopped sloping upwards.

That said, this is still a relatively short-term moving average. Longer, and arguably more important moving averages such as the 200 day, are still solidly sloping upward…..and prices never even came close to falling below it.

So all in all, last week’s price action suggests that beneath the calm surface, the US equity markets are fragile and susceptible to sudden and meaningful drops….at least on a short term basis.

 


The China Factor

May 15, 2017

The S&P500 slipped about 0.35% last week on light volume. S&P volatility didn’t change much—it remained near multi-year lows. In other words, investors are still extremely complacent and not fearing any significant equity market drop.

At the same time, confirming this market complacency is the fact that market prices, despite last week’s tiny pullback, remain near record highs. While the upward momentum on the daily charts is slowing, the technicals point to the possibility of more gains. On the weekly charts, the recent downturn in momentum looks like it’s on the verge of reversing to the upside. So the technicals are saying that while prices are stretched to the upside, even more gains are possible…..at least in the near term.

In terms of US economic data, the story has not gotten better—US macro data is still coming in on the weak side of average. Job openings from the JOLTS survey are not growing much. Retail sales disappointed—at both the headline and core levels. Consumer prices shocked everyone because the core figure on a month to month basis came in at half the expected rate. Even worse, on the year over year basis, the rate dropped below 2.0%, which is the Fed’s important threshold for monetary stimulus; if inflation is below 2.0%, then the Fed usually favors more stimulus. The problem now is that the Fed has started a tightening program but inflation has fallen below its minimum target. On the positive side, business inventories came in stronger than expected and so did consumer sentiment.

Finally, most investors are not aware of the huge role that China has played in the global recovery from the great recession of 2008-2009.  Both its fiscal and monetary stimulus were massively increased, unleashing a powerful reflationary impulse that pushed not only corporate profits around the world upwards, but also many other factors including commodity prices and financial asset prices.

The downside to all this is twofold. First, China financed this huge multi-year stimulus primarily by issuing trillions of dollars (or dollar equivalents) of debt, debt which has now reached such high levels that additional future borrowing has become more difficult to accomplish. Second, the entire policy decision to undertake this stimulus rests with the Chinese government, not the US and not Europe (our allies). So the decision to pull back on such huge stimulus would clearly rest with this same entity, the Chinese government.

Why is this important? Because the Chinese government has recently begun taking measures to reign in its debt growth and as a result, the world could be in for a shock…..because the same stimulus that has propelled the world to recovery over the last eight years may go into reverse and become a deflationary impulse, which could unwind many of the benefits achieved since the stimulus began.

So it will pay investors to watch China closely!


Are Economic, and Market, Cycles Obsolete?

May 8, 2017

The S&P500 gained about 0.6% last week, in very light trading. And volatility remained very low—the VIX index continues to hover near multi-decade lows. The risk here is that a big reason behind the super low level of volatility is the fact that many investors have begun to sell put options on stocks, as a way of supplementing their low returns. The problem of course is that while this strategy may work well in the short term, it may someday blow up in everyone’s face if or when stocks decline by a meaningful percentage. These investors are betting that the stock market will not decline in the near to intermediate future.

In macro news, the week got off to a poor start. Personal spending missed, and so did personal income. Also core PCE, year-over-year (one of the Fed’s preferred measures of inflation), also missed to the downside. In other words, inflation has not risen to the 2.0% threshold desired by the Fed, so its tightening cycle seems to be in conflict with one of its two key mandates. ISM manufacturing also missed. Construction spending missed very badly. On the other hand, ISM services beat estimates. So did international trade and initial jobless claims, which hit a multi-decade low (implying that jobless claims don’t have much more room to fall). Factory orders missed, and productivity missed by a mile (this means that unit labor costs are rising more than expected, and this will hurt corporate profits in the near future). Finally, payrolls beat expectations, and so did the headline unemployment rate. But average hourly earnings only met expectations and the labor force participation rate moved the wrong way—it ticked down.

The technical picture for the S&P has not changed much in the last week. On the daily charts, the S&P is in an upswing. But on the weekly charts, the damage that was done in April has not yet been erased.

Finally, there’s a lot of talk among market pundits that stocks are still a great place to invest most of one’s money and that we shouldn’t worry about a big decline in stock prices; on the contrary, investors should use a dip in prices only to buy more stocks.

One, among many, of the problems with this argument is that implicitly, these stock market bulls are arguing that US economic cycles and US financial market cycles are no longer a threat. In other words, they are implicitly saying that recessions and bear markets have become obsolete….mainly due to the way that the Fed has seemingly prevented any of these threats from materializing over the last 8 years.

So if you buy into the argument that now is still a great time to be massively long the US stock market, then you are also buying into the implicit assumption that US economic and market cycles are obsolete. And if you do, then good luck; you’re going to need it.


S&P500 Valuations Remain Obscenely High

May 1, 2017

The S&P500 jumped another 1.5% last week, but volume was very light so once again, buyer conviction was not all that strong. At the same time, S&P volatility plunged back down close to multi-year lows, where it was back in February of this year.

The technical picture is now showing some divergence between the daily and weekly resolutions.  On the daily charts, the S&P has broken to the upside. The recent, short-term downtrend has been broken and it now looks possible that the S&P could set new record highs, which were last set in February, when the VIX index bottomed. On the other hand, when looking at the S&P on the weekly charts, the breakdown that began in late February looks like it’s still in effect. Momentum, as measured by MACD, is waning and the MACD lines have crossed over into a bearish direction. Of course, if the S&P500 rises another week or two, then this bearish condition in the weekly charts will flip over to a bullish signal and match the daily charts. On the other hand, many technicians….when assessing a divergence between daily and weekly chart signals….tend to favor the longer-term weekly signal because it tends to be more accurate than the shorter-term daily signal.

US macro news was particularly negative last week. The Chicago Fed National Activity Index plunged. The Dallas Fed manufacturing survey missed expectations. Consumer confidence also missed. Durable goods orders, both headline and ex-autos, missed…..with the core reading missing very badly. Pending home sales missed. The Kansas City Fed manufacturing index plummeted. First quarter GDP came in lower than expected. The employment cost index rose more than predicted (this will hurt corporate profits). And consumer sentiment also missed. Only new home sales, international trade, and the Chicago PMI beat estimates. All in all, it seems that both hard and now soft measures of US economic health have started to deteriorate more in the recent month.

Finally, it’s worth noting that valuations in the S&P500 still remain obscenely high. Prices are just a fraction lower than they were at the all-time highs set only a couple of months ago. And extremely reliable measures, measures that have been valid over the last 100+ years of market history, are portraying a US stock market that’s extremely overvalued. How overvalued? Using price-to-sales and price-to-GDP (some of the most reliable metrics available), the S&P500 would need to fall by about 50% JUST to revert back to historical averages. If prices were to overshoot on the downside—which they almost always have done in bear market cycles over the last 100+ years—then the S&P500 would need to fall by about 75%. It sounds crazy, but that’s what history teaches us, and history has always been relevant in predicting and explaining future market outcomes.