BEWARE OF BEAR TRAPS
A Counter Rally No One Believes In
This month’s MATA report explores in detail the Long, Intermediate and Short Term Technical and Economic indicators. We have extracted some of the charts to give Trigger$ readers a better perception of the key drivers underpinning the current rally. A rally that is best labeled as a counter rally. More specifically, a “Bear Market Trap”!
We examine the following:
LONG TERM FUNDAMENTALS - Falling Profits & Weakening Cash Flows
- Credit Cycle Has Turned
- Business Cycle Has Likely Also Turned
INTERMEDIATE TERM RISK
SHORT TERM SENTIMENT – The Trend is now down
- Complacency
EXPECTATIONS – CLASSIC WARNINGS
LONG TERM – FUNDAMENTALS - Falling Profits & Weakening Cash Flows
Pre-Tax earnings probably fell 9.5% in Q4 2015 from a year earlier, after dropping 5.1% in Q3 2015 according to economists at JP Morgan Chase & Co in New York. That would be the biggest decline since the 31% free fall in the closing months 0f 2008 during the height of the financial crisis. For some reason Wall Street doesn’t care?
When we look at divergences going back to 1995 in terms of real profit margins it shows how glaring it presently is. Additionally it shows how it not only resolved itself but often was a tell tale of a pending recession
It would appear that falling earnings are in fact accelerating. We would speculate it is because corporate profits have been used for a number of years now for stock buybacks and financial engineering. Profits were not invested into CAPEX to grow “top line” revenue growth. Crimping investment eventually catches up to you. In our opinion this is what is presently occurring.
Wall Street's recent rise is also stretched relative to the real U.S. economy.
The following chart illustrates the gap between stocks and corporate-profit expectations:
The following chart illustrates how the historic correlation between stock and bond prices is now additionally very distorted:
LONG TERM – FUNDAMENTALS - Credit Cycle Has Turned
We have discussed this in prior Trigger articles that we believe the Credit Cycle has turned.
Falling cash-flows and reduced EBITDA in concert with elevated debt levels (incurred primarily from borrowing to fund stock buybacks) has left corporations cash depleted.
This is forcing credit ratings to be lowered and credit overall to be getting tighter as post QE3 /TAPER sees liquidity tightening.
The credit markets are speaking loudly and the divergences show below WILL BE resolved! It is only a matter of time.
LONG TERM – FUNDAMENTALS – Business Cycle Has Likely Also Turned
Along with the Credit Cycle turning we also see the Business Cycle turning. This time the Federal Reserve may not have the ammunition to fight off a potential looming recession.
However, tumbling US unemployment and surging US inflation is not what really matters to Fed Chairperson 'Global' Janet Yelln. She knows what happened the last time "market" expectations were so dislocated and bullish relative to "economic" expectations. She clearly needs to be cognizant of not wanting to be driving the economic bus off the “Greater Depression” cliff.
A 'hold' in Sept - rally;
A 'hike' in Dec - plunge; and this time
A 'hold' because everything is so decoupled?
"Boxed In" much? "
Global uncertainty" is a suddenly very convenient truth.The Fed knows that any move to tighten ripples through the entire world's collateral chains; and with the global economy already bleeding its deflationary collapse into US economic expectations, a hike is simply piling on.
Don’t expect anymore rate hikes from the Federal Reserve!
INTERMEDIATE TERM – RISK
The last time that global liquidity conditions contracted at this pace was March 2008 (right as stocks dead-cat-bounced on the back of The Fed's guarantee of Bear Stearns' sale to JPMorgan)... and things escalated rather quickly thereafter.
Liquidity conditions also contracted (though not as severely as the current conditions) in Dec 2011. This prompted Bernanke to unleash QE2. h/t financialsense.com
Bloomberg defines BofAML's Global Liquidity Tracker as follows:
Our real-time Global Liquidity Tracker (GLT) is a composite indicator of liquidity conditions in emerging and developed economies. To estimate our GLT indicator, we employ a dynamic factor model used by global central banks. Our Liquidity Tracker extracts a common unobserved factor reflecting the greatest common variation among market spreads, asset prices, monetary and credit data across different frequencies. We combine our US, Euro area, Japan and EM Liquidity trackers into a global composite using financial weights reflecting the average relevance of an economy in terms of market capitalization and private sector credit.
All of this allows us to produce timely estimates of liquidity conditions in an effort to assess the state of the global economy. A reading of zero indicates liquidity at its long-run average while activity between -3 and +3 represents the standard deviation from this average.
Most worryingly - if it wasn't already obvious, given the world's stock markets' total and utter devotion and dependence on central bank-provided liquidity - we have seen this pattern before.
SHORT TERM – SENTIMENT – The Trend is now Down
JPM's Head Quant Explains Who Unleashed The S&P Rally, And What May Happen Next
Since mid-February, the S&P 500 has staged a meaningful rebound. Similar to the market rally in October 2015, systematic strategies had an important role in both the January selloff (here) and February rally (Figure 1).
Short term equity momentum (1-month) turned positive around the 1930 level and 6m momentum turned positive a few days ago. This would have resulted in CTAs covering most of their short equity exposure and inflows in $50-70bn (also confirmed by the equity beta of CTA benchmarks). The market moving higher also changed the index option (gamma) imbalance and resulted in daily hedging flow that suppressed realized volatility. Lower realized volatility in turn led to some (albeit smaller) equity inflows into Volatility Targeting strategies (~$10bn) and Risk Parity strategies ~$10-$20 bn. All In all, over the past 2 weeks, equity inflows from systematic strategies totaled around $80-$100bn. Taking into account the low liquidity (S&P 500 futures market depth) and assuming that total equity market depth is ~4 times that of futures (including stocks, ETFs, and options), we estimate that more than half of the market rally in the second half of February was driven by these systematic inflows. Another likely significant driver is the rally in oil prices over the past 2 weeks.
... and that, as we showed, and as UBS confirmed last Thursday, has been entirely a function of an epic short covering squeeze.
So now that we know who drove the rally, here - according to Kolanovic - is what happens next:
What is the fate of this market rally? In terms of technical flows, more inflows would come if 3M and 12M momentum turn positive, which would happen at ~2025 and ~2075, respectively(the precise level depends on the timing of potential moves). If volatility stays subdued, volatility-managed strategies could also increase equity exposure. However, equity momentum is also vulnerable to the downside and a move lower could be accelerated by 6M and 1M momentum unraveling at ~1950 and ~1900, respectively. From the perspective of systematic strategies, downside and upside risks are balanced. However, equity fundamentals remain a headwind. In our recent strategy note, we showed that historically, periods of consecutive quarterly EPS contractions are often followed by (or coincide with) economic recessions (~80% of the time over the past ~120 years). EPS recoveries that follow 2 consecutive EPS contractions (~20% of times) were typically triggered by some form of stimulus (fiscal, monetary or exogenous). We expect market volatility to stay elevated and investors to remain focused on macro developments such as the Fed’s rates path, developments in China, and releases of US Macro data. Elevated volatility and EPS downside revisions will provide a headwind for the S&P 500 to move significantly higher (via multiple expansion). While investors need to have equity exposure, we think there are better opportunities in Value stocks, International and EM equities (as compared to broad S&P 500 exposure)
Which probably also explains why late last week JPM's head strategists went underweight stocks last week "for the first time this cycle", while urging clients to buy gold.
BofAML's Stephen Suttmeier views the 61.8% retracement of the May-Feb decline at 2010.72 as critically important. A failure to close above this retracement would send a bearish message, especially given negatively positioned and falling 100 and 200-day moving averages.
Key SPX levels: Watch that 61.8% retracement at 2010.72
S&P 500 resistance at 1990-2025 has limited the rally this week. This is a confluence of chart, 100/200-day MA, and Fibonacci levels.
Should the tactical bulls continue their winning ways (with daily momentum staying overbought on a grind higher just like it did into the early November high) the upside count of the double bottom breakout at 2085 comes into focus.
Supports remain 1963-1931 and 1902-1891, which are ahead of the 1812-1810 lows.
SHORT TERM – SENTIMENT – Complacency
If things are bad enough we have complaceny in the markets at extreme levels
Via Dana Lyons' Tumblr,
Data from the volatility market suggests that expectations in the near-term may have finally gotten a bit too complacent.
For the duration of this post-February stock rally, we have been consistent in noting the tepid, or even skeptical, sentiment readings being generated along the way. Along with strong breadth and momentum measures, this lack of belief in the rally has actually been one factor that has enabled its persistence. About 6 weeks in now, however, we are finally getting some preliminary signs of complacency toward the rally on the part of traders.
One such example comes from the volatility market where expectations for near-term volatility have dropped to a historically low level. Most market observers have heard of the VIX, or the S&P 500 Volatility Index. They may not know that the VIX specifically measures the options market’s expectation for S&P 500 volatility over the next month. Another measure, the VXV, indicates volatility expectations over the next 3 months.
Understandably, the VIX normally trades below the VXV as volatility expectations should be lower for a 1-month period than for a 3-month period. However, at rare times, the VIX will trade higher than the VXV. This typically occurs during times of heightened anxiety in the equity markets, i.e., during a decline. Very often, when the VIX has climbed above the VXV (i.e., the ratio of VIX/VXV is greater than 100%), it is an indication that traders are paying up too much on near-term volatility and the stock market is liable to put in a near-term bottom in short order.
Conversely, when the VIX drops to a very low level relative to the VXV, it can be a sign of complacency in the market. While the VXV has only been around since 2007, a possible complacency “trigger” level that has emerged is roughly the 80% mark. That is, when the VIX has dropped to below 80% of the VXV, the stock market has been susceptible to near-term weakness. Over the past 2 days, the ratio has dropped to 78%
As mentioned, the VXV has been around only since 2007. Over that time, the VIX/VXV ratio has dropped to 78% on 4 prior distinct occasions:
March 12-20, 2012 - The S&P 500 chopped sideways for a few weeks before falling some 9% over the next 2 months
August 13-22, 2012 - The S&P 500 chopped sideways for a few weeks before rallying by as much as some 4% over the next few weeks. 2 months later, the index had lost that entire gain, and another 4%.
December 5, 2014 -The S&P 500 immediately dropped 5% over the next 2 weeks before chopping sideways for several months.
March 20, 2015 -The S&P 500 dropped 2.5% over the next week before moving sideways for several months.
Now there is no guarantee that stocks are about to hit an air pocket. However, given the (albeit limited) precedents, the track record in the short to intermediate-term following such readings has not been a positive one. In fact, following the prior 15 days with VIX/VXV readings below 79%, the S&P 500 was lower 3 months later 14 of the days by a median of -3.7%. The only positive return was the 1 point gain following the March 2015 occurrence.
All in all, this may not be a Defcon 5 level red flag for the market. However, for a rally that has seen scant evidence of exuberance, this is at least one of the first indications of complacency.
EXPECTATIONS – CLASSIC WARNINGS
According to DoubleLine's Jeff Gundlach, markets have "2% upside and 20% downside) from here.
Via Dana Lyons' Tumblr,
The broadest U.S. stock index has reached an area of significant potential resistance.
One by one, the averages have been reaching levels on their respective charts that, in our view, represent significant potential areas of resistance. That includes small caps, big caps and, a big index.
The Wilshire 5000 is the broadest index of U.S. stocks. In fact, it cannot get any broader as it encompasses all actively traded stocks in the United States. The index was dubbed the Wilshire 5000 because that was the approximate number of issues trading at the time of its launch in 1974. However, as of June 30, 2015, the index contained 3,691 issues (though, it has retained its name as “Wilshire 3691″ does not have the same ring to it). Although the index is market cap-weighted, its value as a gauge of the broad stock market is obvious.
The Wilshire is presently hitting an area encompassing several points of potential resistance on its chart, including:
The 61.8% Fibonacci Retracement of the June-February decline
The 200-Day Simple Moving Average
The 500-Day Simple Moving Average
These potential price resistance levels are not assured of stopping, or slowing, the rally. They are merely chart analyses that we have found consistent, or at least useful, in the past at highlighting support and resistance levels. What makes the potential resistance argument compelling is
A) The abundance of potential resistance points converging nearby on the charts, and
B) That it is an almost universal condition among all the major indices.
200 DMA - 400 DMA Cross – The Real “Death Cross”
The market is at a critical inflection point.
We believe it is really telling us we are seeing the final stages of this Bear Market Rally.
Caution is advised.
Gordon T Long
Publisher & Editor
general@GordonTLong.com
Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that you are encouraged to confirm the facts on your own before making important investment commitments.
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