Pausing at the Highs

July 31, 2017

Last week, the S&P literally paused, closing essentially unchanged from the prior week’s finish. Well, actually, the index slipped a tiny 0.02% but this change is practically meaningless.

Where does this leave us?  The S&P is still pinned up against all-time highs. The same can be said for the NASDAQ and the Dow. Meanwhile, high yield spreads have collapsed back down near five year lows; this means that high yield bonds are extremely over-priced.

Stock market volatility continues to cling to multi-decade lows. The VIX index spent most of last week below 10, a reading seen less than 5% of the time….in other words a very rare occurrence.

So technically, the S&P remains at some of the most extreme overbought levels ever seen in this index—it’s hugging the upper Bollinger bands on the daily, weekly and monthly charts and it’s well above both the 50 day and 200 day moving averages. At the same time, momentum remains favorable, even though it’s not as strong as it has been in many other periods when prices climbed upward so strongly. On the other hand, one of the biggest concerns coming from technical analysis is the fact that the recent surge in prices has come on declining volumes. Almost all market peaks in the past have occurred on declining volume; while declining volumes doesn’t guarantee that big pullbacks must follow, this situation should at least give investors and traders some reason to proceed with caution.

Finally, the US economy continued to stumble forward. Last week’s reports were mixed to weak… has often been the case for the last several years…..and there’s nothing on the horizon to suggest that the economic growth rates are about to accelerate any time soon.

Let’s see what happens next week.


More Signs of a US Equity Bubble

July 24, 2017

Last week, the S&P500 climbed yet again…..this time adding about 0.5% over the previous week’s close. Volume was very light, as one would expect during the middle of the summer. And not surprisingly, the VIX index slipped back down to the lows of 2017. So US equity prices set new all-time highs, with little investor enthusiasm and with record low levels of fear. What could go wrong?

At the same time, US macro news was mixed. The Empire State manufacturing survey missed badly….coming in about 50% below expectations. US export prices were much lower than anticipated; this hurts corporate profits. The housing market index missed, and the Philly Fed business outlook survey also missed. On the bright side, initial jobless claims were a bit stronger than predicted, and leading indicators beat consensus estimates.

In terms of technical analysis, the picture remains unchanged from the prior week—the S&P500 remains extremely overbought. Not only is the index well above the 50 day moving average, but it’s bumping up against the upper Bollinger bands on the daily, weekly and the monthly resolutions; this is not something we see very frequently.

In terms of valuation, another milestone was hit last week. The S&P500’s Shiller Price to Earnings ratio reached 30, which is where the index peaked in 1929 before crashing by over 70%. While the Shiller PE exceeded 40 briefly in the run up to the dot-com bubble collapse, the current valuation tells us that investors are now in the second most over-valued stock market environment in US history.

Of course this does not mean that a crash, or even moderate correction, is around the corner. But it does mean that the downside risk to being long the S&P500 is probably greater than the upside opportunity for further price appreciation. As simple as this sounds, and as reasonable as it sounds, most investors will go on their merry way—-staying very much invested in the S&P500—-not worrying much about capital losses because everyone else seems to be fully invested in US stocks and besides, with interest rates still so low, there is really no reasonable alternative to stocks. Right?

Bad News Means Stocks Jump?

July 17, 2017

The S&P500 jumped about 1.4% last week, on very low volume. Volatility, as measured by the VIX Index, dropped back down near the lows of the year.

So the technical picture is now more stretched than ever—on both the daily and weekly charts, the S&P is now hugging the upper Bollinger bands and is well above the 50 day moving average.

At the same time, valuations are more stretched than ever. While aggregate corporate profits remain stagnant, the multiples paid for these earnings are approaching record highs. The Shiller CAPE index for example is now approaching highs last seen in the run up to the dot-com bubble in the year 2000.

So what led to this sudden jump up in US equity prices? Unbelievably, it was a series of extremely bad US economic reports. Retail sales plunged; both headline and ex-transportation results were massive misses relative to expectations. Consumer sentiment missed. Core consumer prices and core producer prices also missed to the downside. Initial jobless claims were worse than predicted and the JOLTS survey also missed.

As a result of all this bad news, market traders and investors reasoned that the Fed would be forced to slow down its hiking program. And any slowdown in interest rate hikes is viewed as an accommodation to the equity markets. So bad news equals good news!

Meanwhile, Blackrock…..the major investment management firm….recently published a study showing that almost all the net purchases in the S&P500 since the 2009 bottom have come from only one source—US corporations buying back their own stock. At the same time, individual and institutional investors have been net sellers over this same time frame!

The catch is that most of these corporate buybacks have been funded not from operating cash flows (much of which have been consumed by normal capital expenditures) but by borrowing, borrowing that’s been facilitated by the Fed’s massive drive to lower interest rates. But now that the Fed is reversing its easing programs, these corporations are still left with their huge levels of debt, debt that will now need to be refinanced at higher rates.

So the ingredients are in place not only for a big stock market pullback in the US, but also for a huge corporate debt crisis. Corporations will find that they’re over-leveraged and that they’re interest rates are surging. This suggests that all risk assets—US debt and equities will suffer in the next financial and economic downturn.

Quiet Week in the Summer

July 9, 2017

While tracing out a small yo-yo pattern during the week, the S&P500 ended on Friday almost unchanged from the previous week’s close. Typical of many summer weeks when many traders and active investors take vacations, the volume of shares traded also fell. And in keeping with the sleepy equity market action, S&P volatility also barely moved—it finished the week near the lows of the year.

US economic reports were mixed. PMI manufacturing and construction spending started the week on down notes; both missed expectations. Factory orders also missed. Initial jobless claims  and international trade both missed as well. On the bright side, ISM manufacturing and ISM services both beat consensus estimates. And the big number of the week, payrolls, also beat expectations. That said, other parts of the payrolls report were disappointing—the unemployment rate ticked higher and average hourly earnings missed. So all in all, there is still no strong evidence that the US economy is anywhere close to accelerating out of its multi-year anemic rate of growth.

In terms of technical analysis, the daily chart is continuing to show a bearish momentum pattern in the S&P500. And now that prices are hugging the 50 day moving average, it wouldn’t take much of a drop for this key level of support to get broken. If that happens then look for support at the 200 day moving average which is about 100 points lower on the S&P.

So with a typical July week in the books, the risk asset markets in the US behaved as expected—they didn’t move a lot in either direction. While valuations remain extremely stretched to the upside, the markets appear to be looking for catalysts to move them meaningfully in any direction, either up or down.

Short-Term US Treasuries Pushing Higher in Yield

July 3, 2017

After stalling the prior week, the S&P500 dropped about 0.6% last week. Volume was light—in part because there was very little conviction behind the selling and in part because the slower summer trading season has kicked in. While volatility did jump one day during the week, it was promptly sold off and finished not much higher than it began….still near 2017 lows. One of the most profitable trades for all of 2017 and much of last year is to sell volatility short. The only problem with this trade is that by selling downside protection insurance, traders are assuming just that—the risk that US stock prices do take a tumble and if so, then this “profitable” trading theme will be destroyed in an instant. Until this happens though, its becoming a crowded trade and ironically helps push up US equity index prices by making the price of volatility fall artificially lower than it would be were it not for the crowding that’s going on in the short vol trade.

In terms of technical analysis, the S&P500 has now formed a bearish pattern on the daily charts. Last week’s pullback in prices cemented this signal. Of course, this doesn’t mean that further price drops are imminent or 100% likely to happen, but it does mean that the risk of further drops, in the near future, has gone up….and that investors should be more cautious. On the other hand, the pattern on the longer-term weekly charts is still strongly bullish. Last week’s pullback on the S&P is barely noticeable on the weekly charts, which are showing that the upward momentum is still in effect.

Last week’s US economic reports were mixed to weak. Durable goods orders, both headline and ex-transportation, came in well below expectations. The Chicago Fed national activity index was a disaster. The Dallas Fed manufacturing survey disappointed. The Case Shiller 20 city home price index year on year) missed. The Richmond Fed manufacturing survey also missed. Pending home sales disappointed. Initial jobless claims were weaker than predicted. And Core PCE, one of the Fed’s favorite measures of inflation, came in lower than expected.  On the positive side, consumer confidence beat expectations. First quarter GDP came in a bit better than predicted (still super low, but not as bad as originally feared). Personal income beat expectations, and so did Chicago PMI.

Finally, the Fed’s rate hiking cycle is beginning to make a notable impact on the short end of the US Treasury curve. While the longer end (eg. the 10 year) is yielding less today than it did on January 1st of this year, the 2 year Treasury is yielding far more. At 1.4%, it’s 20 basis points above the 1.2% it yield at the beginning of the year. And more importantly, it’s yielding almost 2.5 times more than it did only a year ago.

The implications are important, because while loans such as mortgages are priced off the longer-term instruments such as the US 10 year, many other forms of consumer and corporate debt are priced off shorter term reference points. So as the US 2 year yield continues to climb, and climb substantially, this will negatively impact US corporate profits and US consumer disposable incomes (ie. their ability to spend will go down and this will also reduce corporate profits).

The bottom line is that the old saying of “Don’t fight the Fed” works both ways:  when the Fed eases, it pays to be long risk assets, but when the Fed tightens, it makes sense to be cautious about being long risk assets. And today, the Fed is in a full-bore tightening mode, so adopting a more cautious investment outlook seems to make a lot of sense.