Monday, July 16, 2012

Waiting for direction

This stock market has been a difficult one for traders and investors alike. The directionless choppiness has combined to create a climate of maximum frustration for many professionals that I have talked to. Unfortunately, the volatility is likely to continue and I am still waiting for signs of direction.

The bear case
For a market analyst, the bear case is easy to make. Cyclical leadership is weakening and defensive leadership continues to be dominant. Consider the chart below of the relative performance of Consumer Discretionary (XLY) against the market (SPY). This sector, which had been the leadership close to two years, has declined through a relative performance trendline, which indicates faltering relative strength.

The relative performance of the Morgan Stanley Cyclical Index tells an uglier story. Cyclical stocks remain in a relative downtrend against the market, with no bottom in sight. If there is an economic rebound, then it should show up in this sector. This weakness is confirmed by recent downbeat comments by Warren Buffett, where he indicated that, across a range of Berkshire's businesses, growth was decelerating.

The Technology sector continues to look sick. The chart below shows the relative performance of the equal weighted NASDAQ 100, which takes out the strength of heavyweights like Apple, relative to the market.

In the meantime, defensive sectors such as Consumer Staples continue to lead.

Investors have also gone wild for yield, which has pushed up the relative performance of Utilities. This sector appears to be consolidating its relative gains after a period of outperformance.

In addition, Mark Hulbert reports that insiders are selling more than normal, which is bearish. The macro picture is full of risks. China is slowing and is at risk of a hard landing. Europe isn't resolved and the US, as shown by the analysis above, appears to be slowing in the face of the upcoming fiscal cliff.

Don't be too eager to go short
On the other hand, I wouldn't be too eager to get overly bearish here. Long-term sentiment measures are screaming "buy". Citigroup's Panic-Euphoria indicator (via BusinessInsider) is flashing a panic signal indicating a 97% chance of a rally.

The same goes for BoAML's Buy-Side Indicator. Equity strategist Savita Subramanian wrote [emphasis added]:
After triggering a Buy signal in May, our measure of Wall Street bullishness on stocks declined again, marking the ninth time in eleven months that the indicator has fallen. The 0.8 ppt decline pushed the indicator down to 49.3, the first time below 50 in nearly 15 years, suggesting that sell side strategists are now more bearish on equities than they were at any point during the collapse of the Tech Bubble or the recent Financial Crisis. Given the contrarian nature of this indicator, we are encouraged by Wall Street's lack of optimism and the fact that strategists are recommending that investors significantly underweight equities vs. a traditional long-term average benchmark weighting of 60-65%.

In fact, the safe haven trade looks awfully crowded here. I know there have been lots of voices calling for a Treasury bond bubble, but consider how far the safe haven trade has gone: France, which less has not been a model of fiscal restraint but got lumped in with Germany by the market, has its 5-year paper yielding less than 1%.

In fact, 10-year French yields are trading at all-time lows in a history that stretches back to the 1700's.

With long-term sentiment models showing this much bearishness, traders who go short run the risk of getting their faces ripped off in a market melt-up on any hint of positive news, as they did Friday.

Signs of stabilization?
I am starting to see signs of stabilization. Despite the huge macro risks overhanging the eurozone, the EURO STOXX 50 has staged an upside breakout from a downtrend and appears to be trying to put in a bottom, which indicates that the worst may be over.

Commodity prices, which are highly sensitive to China's growth outlook, also appear to be bottoming.

I have had comments from readers that the rise in commodity prices may be related to the rally in the grains, which is weather related. A look at the price of Dr. Copper, which is not weather sensitive, also shows a similar pattern of stabilization.

No capitulation yet
Long-term investors may be tempted to get long here, but I would also caution against going all-in because we have not seen signs of investor capitulation yet. In the most recent bout of market weakness, a broker contact I had told me that clients were calling up to ask, "Is it time to buy yet?"

These are not signs of a durable intermediate term bottom.

My indicators of asset relative performance are not showing signs of a wash-out in sentiment either, though they are getting close. This chart of the relative performance of SPY against TLT, which represents long Treasuries, is getting close to panic levels, but not yet.

Similarly, a longer term chart of Canada's Venture Exchange Index of junior stocks against the more senior TSX Composite is telling the same story. Getting close, but we need a bit more pain.

Moreover, the upside for the bulls may be limited. We have been in a range-bound market since the NASDAQ peak in 2000. If the trading range were to continue, then the upside potential for the bulls may be limited at these levels.

A market of maximum frustration
In short, this has been a market of maximum frustration. My inner investor is accumulating positions, but he is afraid that we could see a downdraft on some dramatic news that could take the market down 20%.

My inner trader doesn't know what to do. His instincts tell him to get short, but the risks of a rebound are too great. He is mostly stepping aside and waiting for market developments to give him an indication of direction.

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.

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