The most watched and talked about financial market in the world is the US equity market. The most watched, analyzed and talked about proxy for the US equity market is the S&P 500.
As we close February, now is a good time to take step back from the daily price action and the deluge of economic data, to assess exactly where the US equity market is heading next.
At the end of January, you would have thought that the world was ending. The S&P declined 11% to start the year, but staged a good rally back to finish the month down just 4.5%. People freaked out because they aren’t used to a decline in the S&P 500, certainly not with the unparalleled global monetary policy. One month later and the S&P essentially has moved sideways over the last 4 weeks. This has people everywhere asking where do we go from here? Is now the time to buy stocks? Is the decline over?
The technical picture for the S&P 500 is pretty straightforward. There are 2 trading ranges that anyone with a chart can see. I’ll use SPY, the S&P 500 ETF, since that’s the way you can trade the S&P 500. The first range, where the S&P spent most of 2015 outside of the August debacle, is from 210 to 193.
The second range, which was prevalent in 2014, is back now in 2016, between 195 and 180. These are the ranges everyone is trading and SPY is chopping around the middle of these two ranges. Since there isn’t a lot of nuance to discuss technically, let’s turn our attention to the fundamentals and the current sentiment to see if we can glean some insight into the direction of the S&P that others may not see.
Fundamentally, not much has really changed in the first 2 months of the year. The fact that US economic data is improving over the fourth quarter is good but frankly not impressive, given the low bar that Q4 set and it's merely the start to a conversation; it’s not the full story.
One of the bright spots in the US economy so far this year has been the data surrounding the consumer. The all important retail sales bottomed in October and has accelerated higher each of the last 3 months. Personal income bottomed in September and after flat lining for the end of 2015, it took a nice bump higher in January. We’ll have to wait and see if February’s data shows the US consumer is continuing to consume at a healthy level.
The labor market has been doing fine but pretty tepid as compared to last year’s pace. Non-farm payrolls peaked in October and have fallen in each of the last 3 months. ADP employment had a huge spike in December but then fell off a cliff in January. That said, the rate of job growth was above the 2015 average.
My preferred labor stat, the weekly unemployment claims, spiked in early January but since then has resumed its downward trend and is hovering just above 40-year lows.
When we dig into the activity level in both the service and manufacturing sectors, things get a bit uglier. The service sector has been in a downtrend since peaking during the Summer 2014 and just entered into contraction during February. This follows the trend in manufacturing, which peaked in early 2014 and has been slowing ever since and remains just above the level that would indicate contraction.
And to top it off, industrial production also peaked in 2014, has been down trending ever since and has been in flat out contraction for each of the last 3 months. Is it any wonder that less than 2 months into the year, Yellen has already been hedging her bets a bit and backing off the 2-4 rate hikes this year talk?
The fundamental data has fallen off a cliff so the current growth environment is certainly not conducive to higher equity prices or the S&P 500 breaking to all-time highs. But as we know, fundamentals don’t drive markets over the short term, investor sentiment does.
There are a variety of sentiment indicators available to us but there are three that I find the most interesting right now. From a bullish perspective, there are several things working in the bulls favor.
First off, the American Association of Individual Investors has a weekly sentiment survey, which measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months. The current number of bulls in this survey is lower than it was in both March 2003 and March 2009.
As a quick history lesson, March 2003 marked the bottom of the Tech Crash and March 2009 was the bottom of the Financial Crisis. The S&P ripped higher for multiple years after those two events. So the fact that sentiment appears to be more bearish now is extremely bullish from a contrarian perspective.
Another survey that is flashing a bullish signal is the Bank of America ML survey of Fund Managers. Those guys are sitting on the most cash since November 2001. That’s more cash than either the bottom of the Tech crash or the Financial Crisis which we just touched on.
In addition to a huge cash position, the average fund manager has also reduced the amount he is overweight equities from 21% down to just 5%. This is the lowest weighting to equities since 2012. So to summarize, the guys that are paid to be in equities are heavily in cash and whatever positions they do have on right now, they are grossly underweight equities compared to normal allocation standards.
The last sentiment indicator that caught my attention was the current level of short interest. In the last two months, NYSE Short Interest has risen 5%, back over 18B shares, which is closing in on the historical record highs of July 2008.
The amount of shares SHORT have increased in the 7 of the last 9 months. So this has been building up since the middle of last year.
There are two very different ways to interpret what this record amount of bearish positioning means. We could get a central banking intervention or another event that forces these short sellers to cover their positions causing the mother of all short squeezes, which in turn will push the S&P back towards its all-time highs.
Or, this level of short interest is predicting the same as the record short interest in July 2008, which correctly foreshadowed the biggest financial crisis in history and another historic market collapse is just around the corner. Only time will tell which of these perspectives is the correct one.
My takeaway from the trifecta of fundamental data, price action and sentiment is that I expect the S&P to rally but then rollover again and make new 2016 lows.
You could certainly trade the rally if you like counter trend moves but I would keep the trade on a short leash. For those with LONG exposure; I would use any move in SPY towards the 200-210 range as an opportunity to lighten up on US equities.
And for those of you who are inclined to SHORT markets to benefit on a decline, you can use rallies to initiate new SHORT trade ideas but be cognizant of the ranges that I pointed out at the beginning of the commentary. I’m carrying a SHORT bias on SPY in our Focus Market commentary and nothing I’ve seen so far this year has me questioning that posture.