Friday, March 24, 2017

Weekly Market Summary

Summary: US indices have fallen nearly every day since the FOMC raised the federal funds rate on March 15th. This week, the SPX also experienced its first 1% daily loss in 109 days, bringing one of the longest such streaks in history to an end. There are a number of reasons to expect equities to be at or near a point of reversal higher. A retest of the recent high is likely.

That said, it's a good guess that the market's period of smooth, persistent strength over the past 4-5 months has come to an end. Higher volatility and more days with 1% losses (and 1% gains) lie ahead.

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After a strong start to the year, the US indices have turned weak. Since the FOMC raised the federal funds rate on March 15, SPX has closed lower 6 days and higher only once. The 13-ema is now declining, indicating that the intermediate trend is down. There has been no reversal in price, yet, but there are several reasons to believe that a reversal may be near.

On Tuesday, after 109 days, the S&P finally fell more than 1% during one trading day. This was the third longest streak without a 1% loss in the past 36 years.

The charts below look at the 5 prior times since 1980 that SPX went more than 95 days without a 1% fall. It's a small sample but there is a consistent pattern: the index rallies at least 2-5% in the ensuing weeks. Within 2 weeks, SPX was back at its prior high 4 times. The one exception was 1993, which was also the only time that SPX was below its 50-dma; even then, it returned to its high within 2 months. In the other 4 instances, SPX was above its 50-dma, like now. Enlarge any chart by clicking on it.

Wednesday, March 22, 2017

Fund Managers' Current Asset Allocation - March

Summary: A tailwind for the rally over the past year has been the bearish positioning of investors, with fund managers persistently shunning equities in exchange for holding cash.

Sentiment has turned bullish.  Optimism towards the economy has surged to a 2-year high and profit expectations are near a 7-year high.  As a result, global allocations to equities rose to a 2-year high in March and "risk appetite" is also at a 2-year high. All of this suggests the big tailwind for equities has now dissipated. The one remaining positive is the high cash balance at funds.

Europe and Japan are now the most overweighted equity markets on a relative basis. Allocations to the US have dropped as the region has underperformed so far in 2017; this is where US equities typically start to outperform again. The weighting towards emerging markets has jumped in the past two months; this is now back to where the last two rallies in that region have started to fade.

Findings in the bond market are still of greatest interest. Inflation expectations are at 13-year highs, a level at which yields have reversed lower in the past.  Fund managers' allocations to global bonds fell to a more than 3-year low in March, a level which has often marked a point of capitulation.

For the fourth month in a row, the dollar is considered the most overvalued in the past 11 years. Under similar conditions, the dollar has fallen in value in the month(s) ahead.

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Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal. We did a recap of this pattern in December 2014 (post).

Let's review the highlights from the past month.

Cash: Fund managers' cash levels dropped from 5.8% in October 2016 to 4.8% in March. Recall that 5.8% was the highest cash level since November 2001. Cash remained above 5% for almost all of 2016, the longest stretch of elevated cash in the survey's history. Some of the tailwind behind the rally is now gone but cash is still supportive of further gains in equities. A significant further drop in cash in the month ahead, however, would be bearish. Enlarge any image by clicking on it.

Monday, March 20, 2017

Households' Equity Ownership Reaches 30%. It's Statistical Noise

Summary: Households have 30% of their financial assets in equities, the same proportion as they held at bull market peaks in the 1960s and in 2007. Does this mean another bear market is imminent? No. Two of the last three times the purportedly significant 30% level has been reached, stocks gained another 40-60%. The level is statistical noise.

Households' equity ownership proportion mostly reflects the appreciation in the stock market: their equity proportion fell almost in half in the last bear market yet during this time, investors actually added new money to equity funds. The level of households' assets in equities seems to closely predict high and lows in the stock market because they both measure the exact same thing: the level of the stock market.

There are better ways to measure investor sentiment and valuations, both of which, like the equity proportion, rise during bull markets and fall during bear markets.

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Chances are you have seen a chart like the one below. It shows US households' equity ownership as a proportion of total household financial assets (blue line) versus the stock market (red line).  The message is usually this: US households now own more equity than at the stock market peak in 2007. It's a sign that another bear market is imminent. Enlarge any chart by clicking on it.

Sunday, March 12, 2017

The Set Up As The FOMC Get Ready For A Third Rate Hike

Summary: The FOMC is likely to enact a third hike in the federal funds rate this week. With economic data continuing to be good, the risk to equities of a rate hike is small. Higher rates indicate continued economic growth, so equities, commodities, the dollar and yields generally respond positively. However, the recent picture is more mixed: in particular, the dollar and yields have sold off after rates have been hiked. This was not the consensus' expectation, nor is it this time. Is another surprise likely now?

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On Wednesday March 15, the FOMC is likely to raise the federal funds rate (FFR) for the third time during the current economic expansion. We wrote about what to expect ahead of the first rate hike here and the second rate hike here.

The Fed chair and its governors have very clearly signaled their intentions in advance of this meeting. The market places the probability of rate hike at over 90%. In just over a week, 10 year treasury yields have jumped 30 basis points (bp) to their highest level since December 15.

Why has the Fed telegraphed their intentions to the market so clearly? Doesn't this tie the FOMC's hands should interim data make a FFR hike unnecessary?

The FOMC has learned that surprising the market with a FFR hike is a very bad idea. With the SPX rising 15% since the election, a surprise would likely catalyze a big drop. Here are two examples of how this has happened in the past.

The 1966 bear market is one of only two bear markets since the 1940s that occurred outside of a recession. The approximate cause: the FFR was rapidly and unexpectedly raised from 4% to 6% (read more here).

More recently, the FOMC surprised the market with just a 25 bp FFR hike in February 1994. Going into the meeting, the market put only a 20% probability of a hike. What happened next? The SPX fell 10% in the next two months. So keeping the market constantly prepared for a possible change in the FFR has been the FOMC's modus operandi for a long time.

Friday, March 10, 2017

March Macro Update: Housing Sales and Starts Rebound

SummaryThe macro data from the past month continues to mostly point to positive growth. On balance, the evidence suggests the imminent onset of a recession is unlikely.

One concern in recent months has been housing, but revised data shows housing starts breaking above the flattening level that has existed over the past two years. A resumption in growth may be beginning.

That leaves employment growth has the main watch out: employment growth is decelerating, from over 2% last year to 1.6% now. It's not alarming but it is noteworthy that expansions weaken before they end, and slowing employment growth is a sign of some weakening that bears monitoring.

Overall, the main positives from the recent data are in employment, consumption growth and housing:
  • Monthly employment gains have averaged 196,000 during the past year, with annual growth of 1.6% yoy.  Full-time employment is leading.
  • Recent compensation growth is the highest in nearly 8 years: 2.8% yoy in February. 
  • Most measures of demand show 3-4% nominal growth. Real personal consumption growth in January was 2.8%.  Real retail sales grew 2.9% yoy in January.
  • Housing sales grew 6% yoy in January. Starts grew 10% over the past year.
  • The core inflation rate is ticking higher but remains near the Fed's 2% target.
The main negatives are concentrated in the manufacturing sector (which accounts for less than 10% of employment):
  • Core durable goods growth rose 2.2% yoy in January. It was weak during the winter of 2015 and is slowly rebounding in recent months. 
  • Industrial production has also been weak; it's flat yoy due to weakness in mining (oil and coal). The manufacturing component grew 0.5% yoy in January.
Prior macro posts are here.

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Our key message over the past 4 years has been that (a) growth is positive but slow, in the range of ~3-4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely.

Modest growth should not be a surprise. This is the typical pattern in the years following a financial crisis like the one experienced in 2008-09.

This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels. The saying that "the stock market is not the economy" is true on a day to day or even month to month basis, but over time these two move together. When they diverge, it is normally a function of emotion, whether measured in valuation premiums/discounts or sentiment extremes (enlarge any image by clicking on it).

A valuable post on using macro data to improve trend following investment strategies can be found here.

Let's review each of these points in turn. We'll focus on four macro categories: labor market, inflation, end-demand and housing.

Employment and Wages

The February non-farm payroll was 235,000 new employees plus 9,000 in revisions.  In the past 12 months, the average monthly gain in employment was 196,000. Employment remains solid.

Monthly NFP prints are normally volatile. Since 2004, NFP prints near 300,000 have been followed by ones near or under 100,000. That has been a pattern during every bull market; NFP was negative in 1993, 1995, 1996 and 1997. The low prints of 84,000 in March 2015 and 24,000 in May 2016 fit the historical pattern. This is normal, not unusual or unexpected.