Santa Claus Rally in the S&P500?

December 28, 2017

Last week, to absolutely nobody’s surprise, the S&P500 closed with another gain, a small gain but a gain nonetheless. This time, the increase was +0.28%. Volume was very light, and volatility hovered near all-time lows. The low volume and low volatility was also not surprising because this was the week before the Christmas and New Year holiday weeks.

The technical picture hasn’t changed much in the last several weeks. On the weekly charts, the S&P500 looks like it’s enjoying a parabolic blow-off topping run. When it ends, nobody knows. But until it does, the clear trend is not only to the upside, but also at a very steep trajectory. On the daily charts, while the trend is undoubtedly bullish, there is a bit of a slowdown in momentum given the relatively small percentage increases over the last few weeks. That said, it’s too early to read any sort of reversal into this momentum slowdown on the daily charts.

The most recent data on the US economy continues to show that the economy is limping along slowly, certainly not about to slow down anytime soon, but also not about to take off with strong and robust growth. Last week, durable goods orders, both headline and ex-transportation, missed badly. Initial jobless claims surprisingly came in weaker than expected. Third quarter GDP registered a weaker reading than economists had predicted. The Chicago Fed National Activity Index missed. Personal income missed. Consumer sentiment as well as the Kansas City Fed manufacturing index also both missed. On the positive side of the story, the housing market index beat expectations, and so did housing starts and existing home sales. The FHFA house price index registered a beat, and so did the Philly Fed business outlook survey. Leading indicators beat consensus estimates. Personal spending recorded a beat, and so did new home sales.

All in all, the US housing market continues to show resilience, even as prices have returned to….or in some cases exceeded….former all-time high levels reached in 2006. At the same time, many other aspects of the economy, such as real wages, continue to struggle to improve.

Finally, in the last week of the calendar year, it’s not going to surprise anyone if the S&P500 records yet another week of weekly gains. This is the week between Christmas and New Year’s when many investors and traders go on vacation….and historically during this week, the risk asset markets have tended to creep higher, not by much, but upwards nonetheless.

Let’s see what the new year brings us, starting with the first week of 2018, which begins next week.

Does the S&P500 Need a Catalyst to Spark a Correction?

December 18, 2017

Here we go again. Like clockwork, the S&P500 advanced another week. This time it added about 0.9%, on top of record high levels reached the week before. Volume was modest. And volatility was almost non-existent; the VIX index ended the week once again below the 10 level, a level rarely reached over the last 20 years.

In terms of US macro news, the results were mixed last week. In the JOLTS survey, job openings missed. Producer prices, both headline and core, came in hotter than expected. So there’s more upstream inflation than economists had anticipated. Consumer prices, on the other hand, met expectations; core CPI, however, came in lower than expected. So there’s little evidence of downstream inflation heating up. PMI composite flash came in weaker than expected, and industrial expectations also missed. On the positive side, initial jobless claims were better than predicted; they’re now lower than they’ve been in decades. And retail sales also beat consensus estimates.

In terms of technical analysis, the over-stretched condition in the S&P500 just keeps on getting more distorted, ie. over-stretched. On a monthly basis, prices have now deviated from the two-year moving average by a large percentage than they did near the peak of the 2000 tech bubble. Prices on this measure are so stretched that it would take a roughly 15% correction to just bring them back to this super long-term moving average. Keep in mind, this type of correction would not even break the uptrend. In other words, even if a 15% correction materialized, many technicians would argue that the bull market cycle would still be in effect! It would take a far larger drop to break this bull cycle.

So many market analysts are asking—exactly what type of catalyst would be needed to spark such a larger correction, a correction that has ended every bull market cycle in the history of US equity markets?

And surprisingly, given today’s market action, more and more analysts—analysts who should know better—are starting to argue that with the Federal Reserve supporting US risk asset markets with current and with potential monetary easing, that for the first time in US financial market history, US stock market investors should not worry about any major correction. Instead, they should continue to confidently buy every minor dip….and continue “making money” year in and year out with US equity markets.

These analysts argue that even if some sort of huge catalyst were to appear—think war with North Korea—that the Fed would simply open up the monetary firehose and push prices right back up to where they were…and then even higher to new all-time record highs.

In short, according to the new conventional wisdom, stocks cannot go down. And if they even so much as suffer a hiccup then the wise investor should be thankful for the short-term “sale” and just buy more.

The problem with this thinking is that many analysts assume that some sort of big catalyst would be needed to start—even if temporarily—a US stock market decline. What if the fundamental reason for the future decline is simply a matter of obscene valuation?  If the Shiller P/E of the S&P500 reaches say 30, then will it be the fault of some war (against North Korea, or anyone else) that really causes the S&P500 to fall by more than 15%?  Or will it be the fact that investors collectively pushed the S&P500 to obscenely high valuations …..and that a trigger, ANY trigger, was all that was needed to create fear among investors who would collectively….yet unsuccessfully….all rush for the exits?

Given the fact that a huge percentage of today’s traders are too young to have ever experienced a bear market, and given the fact that in risk asset markets in general, all investors tend to forget the lessons—and losses—of the past because they’re too absorbed with the paper gains of the present, it’s very likely that when the next bear market finally arrives….and it will….that the cited “catalyst” for the correction will only be a diversion, an excuse, for what only a few long-term investors will rightfully point out to have been the cause—excessive valuation that was reversed by a collective change in market psychology, a psychology emphasizing greed that suddenly shifted to a psychology of fear.

What the US Treasury Yield Curve is Telling Us

December 11, 2017

To nobody’s surprise, the S&P500 continued to melt up. Last week it climbed another 0.35%. Volume was light. And volatility was almost non-existent: the VIX index closed back down below 10, which historically has rarely been reached.

The technical picture remains unchanged from last week—the S&P500 is a market that’s extremely over-stretched on the daily and weekly resolutions. Last week’s modest advance in the index did nothing to change this condition.

In US macro news, most of the reports were disappointing. International trade missed. PMI services and ISM services also both missed. Productivity came in lower than expected; as a result, unit labor costs rose more than expected. consumer sentiment disappointed. Wholesale trade missed badly. And in the US payrolls report for November, the average hourly earnings were lighter than predicted. On the positive side, factory orders fell less than predicted. Consumer credit grew more than expected. And in the payrolls report, more jobs were created, and the average workweek was slightly longer than expected.

Recently, market analysts have spotted an interesting development in the US yield curve. While the curve is still positively sloping (ie. the 10 year Treasury is yielding more than the 2 year UST), the difference between these two maturities has been collapsing over the last couple of years. This is important because in almost all of the most recent market and economic slowdowns, something similar has also happened…but well before these slowdowns actually hit. Specifically, the 2 year and 10 year have always inverted; that means that the 2 year yield exceeded the 10 year yield, creating a downward sloping yield curve.

Even more interesting was the timing of this development. The most recent two yield curve inversions preceded the subsequent market and economic retreats by about 18-24 months. So while today’s curve is only approaching inversion, when it finally arrives (and the Fed’s rate hikes have been the key driver of the recent curve flattening) when the Fed raises short-term rates several times over the next 12 months, history shows that a market slowdown is almost sure to follow….but only 18 to 24 months after the inversion first appears.

So is the yield curve telling us that the bull market in US risk assets has another two years to go?

US Stock Market Psychology is at Extreme Highs

December 4, 2017

Incredibly, the S&P500 rose again last week. This time it jumped by about 1.5%. Volume was very light….so no huge surge in investor conviction. And counter-intuitively, S&P VIX also jumped, suggesting that while the retail masses are comfortable owning stocks….and even buying a lot more….some more sophisticated investors and traders are buying downside insurance.

Was there some sort of surprising economic news to power the S&P forward last week? Nope, not at all. In fact, the last week’s reports were filled with disappointments. The Dallas Fed manufacturing survey missed, for example. But there’s much more—international trade in goods, the FHFA house price index, wholesale inventories, PMI manufacturing, and the ISM manufacturing index all disappointed versus expectations. On the positive side, new home sales, consumer confidence, pending home sales, personal income, and Chicago PMI and construction spending all beat expectations. So the bottom line is that the US economy has not suddenly improved, which could explain last week’s surge in US stocks.

Technical analysis is showing a US stock market that’s almost disturbingly overstretched to the upside. On both the daily and weekly charts, prices are literally moving off the charts…to the upside.

Meanwhile, valuations have now approached the two most overvalued levels in US history—the period just before the 1929 peak, and the period just before the 2000 peak. In both cases, crashes—massive crashes—ensued. But in the period leading up to those crashes investors were largely euphoric….and still heavily long US stocks.

And this same phenomenon is now occurring today. Specifically, investor psychology is now so bullish, that virtually all negative news can spark any meaningful selling in US stocks. On the contrary, any small “dips” are immediately bought, often within hours of the dips occurring. And keep in mind that some significant, and normally bearish, news has been released over the last several months. In geopolitics, North Korea is now literally capable of hitting the US mainland with a nuclear weapon. In terms of monetary policy, the Fed has not only already started raising interest rates and reducing its balance sheet, but it’s communicated that this policy will continue for at least another year. And the US yield curve is flattening and soon possibly inverting, a condition which almost always precedes not only a US economic recession, but also a major market correction.

But today, in US equity markets, nothing negative seems to matter, except one thing—the absolute conviction by investors that stocks will continue to go up, despite all the risks outlined above, and that the only rational thing to do is to continue to own them….and to buy them.

Some day this will change; it always does. But until then, it’s not worth fighting the trend, which is still–clearly–bullish. And when this trend, and market psychology, finally reverses, it’s especially important to remember that almost everyone who’s currently long will get hurt. It will be impossible for the average investor….and even for most pros….to get out before the drop has severely taken away a big chunk of their current paper profits.