Monday, April 16, 2012

Stay long, but keep tight stops

Have US equities seen an intermediate term top? It was a rough week for stocks last week, but I believe that we are due for an oversold relief rally. We will need to watch how the market behaves in the next couple of weeks in order to truly determine whether an intermediate term top is in.

As the chart below shows, the market briefly tested the 50-day moving average and managed to rally above that support level and the longer term uptrend remains intact.

The market is certainly oversold, as shown by my favorite overbought/oversold indicator.

As well, sentiment readings have deteriorated rapidly, as reported by Bespoke:

In addition, Barry Ritholz pointed out that funds flows into equity mutual funds have turned negative again, indicating that the public has never really fully embraced the stock market rally. Indeed, John Kozey of Thomson Reuters writes in an article entitled The Contrarian Signal: Money flows favors stocks over bonds:
You would be forgiven for imagining that investors are allergic to owning stocks, given the data surrounding equity fund flows. For the last 12 months, as shown in Chart 4, below, investors have demonstrated at best a grudging affection for stocks.

These are typically not the kind of levels of sentiment indicator readings that mark the start of a major decline.

The NFP release a statistical blip?
In addition, the shocker of a 120K NFP release that was the catalyst for the recent stock market selloff may have been a statistical blip. Ed Yardeni outlined last week why he remains constructive on employment picture:
(1) The three-month average gain of payroll employment remains solid. Payrolls rose 211,700 per month on average during Q1-2012 vs. 164,000 during Q4-2011 and 127,700 during Q3-2011. Private-sector payrolls rose 210,300 on average during Q1 according to the official tally, in line with the 207,000 average gain for the payrolls tracked by ADP.

(2) The index of aggregate weekly hours worked for total private industries rose at a solid pace during Q1. It was up 3.7% (saar), following increases of 2.5% during Q4-2011 and 1.1% during Q3-2011.

(3) The household employment survey is up 414,700 per month on average over the past three months. That compares to gains of 227,700 during Q4-2011 and 240,700 during Q3-2011.

(4) According to the household survey, full-time employment rose 882,000 during March! That’s not a typo, and that’s after it rose 563,000 during February. On the other hand, part-time employment fell 664,000 during March after falling 163,000 during February. Full-time employment is up 4.8 million since its latest cyclical trough during December 2009 to the highest level since the start of 2009.

Also consider the latest batch of other employment indicators:

(5) During March, initial unemployment claims averaged 361,750, falling steadily from September’s average of 410,500. That’s a clear sign that the pace of firing is continuing to decline.

(6) A monthly employment index, which can be constructed from the available regional surveys conducted by the Fed districts and purchasing managers associations, remains strong. So far for March, data are available for the regions around the following cities: Chicago, Dallas, Kansas City, New York, Philadelphia, and Richmond. The average of these regional indexes fell from 14.5 during February to 12.2 last month. That’s still a relatively high reading.

(7) On Wednesday, Gallup reported a four-point jump in the polling firm’s Job Creation Index from 14 in February to 18 in March. That’s the best reading since August 2008. The latest poll also found that the pace of hiring is picking up: “The March Job Creation Index reflects 35% of U.S. adult workers saying their employers are hiring and expanding the size of their workforces, and 17% saying their employers are letting workers go and reducing the size of the workforces. While the percentage letting go matches what Gallup found in January, the percentage hiring is at a 42-month high, last seen in September 2008.”

(8) The employment component of the national manufacturing purchasing managers index (M-PMI) jumped from 53.2 in February to 56.1 in March, the best reading since last June. The nonmanufacturing survey’s employment index increased from 55.7 in February to 56.7 in March. The average of the M-PMI and NM-PMI employment indexes rose to 56.4 in March, the highest since last June.

(9) Wednesday’s ADP report also confirmed that the labor market remained strong during March. During Q1, the average gain was 207,000, little changed from Q4’s 211,700 and considerably above the 99,000 average during Q3 of last year.
As well, the latest data shows March witholding tax collections continues to be strong, which all point to continued strength in employment. Gallup also reported that Americans' Spending Up Sharply in March, indicating that American consumer strength appears to be unrelenting.

What the bears say
Based on the analysis so far, one may be inclined to give the bulls the benefit of the doubt, but inter-market analysis reveals a far more bearish tone. There are a number of worrisome negative divergences that shouldn't be ignored. For one, eurozone concerns are rising and the risk of financial contagion from Europe is rearing its ugly head again. European stocks have violated their uptrend and they have rolled over. The STOXX 600 Index, shown below, is now approaching the first technical support at the 61.8% Fibonacci retracement level.

In addition, commodity prices look punk.
The relative performance of the Morgan Stanley Cyclical Index is also following the pattern of commodity prices.
If we are truly seeing a recovery in the American economy, shouldn't cyclical stocks be outperforming? In summary, we have trouble in Europe, weakening cyclicals and commodities. Do these look like the ingredients for a sustainable advance?
Staying on hold, but watching
Today, what we have right now is an oversold market that is due for a relief rally of at least 1-2 weeks in duration. In the meantime, Earnings Season is upon us with the possibility of margin compression weighing down the market (see my post Bad news is good news, good news is...). I am watching earnings reports carefully for whether margin compression is occurring this quarter, as I have to allow for the possibility that it may be pushed out to the next quarter's earnings reports.
In summary, I wrote before that investors should maintain a balanced outlook between risk and return (see Time to take some risk off the table). My current stance is to watch how the market behaves and reacts to news in the next few weeks in order to get a better idea of intermediate term direction. Specifically, I am watching for:
  • Earnings and forward guidance: Are margins compressing now or next quarter?
  • Market leadership: How are the cyclicals and commodities behaving?
  • European news, as we have elections in France and Greece coming up soon and the fear of European contagion could rise.
Stay long, but keep tight trailing stops in place.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

1 comment:

Anonymous said...

This post is why I look at your blog every day. I learn from you. I just stole your oversold indicator. I use a different one, and have different sentiment indicators, as well as a different take on the economy, but I agree with your conclusion. Thanks!