Monday, January 14, 2013

Big tests for stocks

It would be so easy to get bearish on stocks here. Last week, there was lots of buzz in the blogosphere about how investor sentiment had gotten overly bullish, which is contrarian bearish. The AAII sentiment readings have certainly moved into a crowded long region (via Pragmatic Capital):

The blogger Right Side of the Chart also voiced a similar warning, with further analysis showing how stocks have performed in the wake of past crowded long readings:

In addition, EPFR reported that investors had turned positive on equity funds after a long hiatus as the last time that such flows into equity funds was seen was September 2007. Mark Diver of Nomura (via FT Alphaville) indicated that such flows represented a contrarian sell signal:

Even David Rosenberg quipped in last Friday's Breakfast with Dave that:
As for the USA, almost everyone I talk to is now bullish. There are many folks out there that think that even I have turned bullish...

A mixed sentiment picture?
Maybe I am over thinking this: The sentiment picture seems just a little too neatly packaged to me and it would be just a little too easy to be overly bearish here. Positive flows into equity funds after a long winter of negative flows could be interpreted as positively as the return of bullish momentum. Indeed, Schaeffer's Research reported enormous buying of VIX calls last week as a bet on rising volatility (and falling markets), which is contrarian bullish. I heard several talking heads on CNBC late last week cited the same kinds of reasons to be bearish from a sentiment viewpoint.

While I understand that sentiment models, on an intermediate to longer term time horizon, can give a bearish picture, but is too much trader bearishness supportive of the markets here?

Some big tests coming up
Notwithstanding the sentiment model readings, here are the key tests that I am watching for the stock market.

First, how stocks react to news is always an important indication of market direction. How will the market react to the news that the White House has ruled out the trillion dollar coin as a solution to the debt ceiling impasse? As I write these words, overnight ES futures are slightly positive indicating a lack of anxiety over the elimination of one solution to the debt ceiling debate.

The Treasury is expected to run out of money somewhere between February 15 and March 1. Here is a chart from January 10 (via Business Insider) of how the Dow reacted the last time we had a debt ceiling debate. Complacency reigned, until about a week before the impasse. At that point, the market began to crater. The reaction this week to the end of the trillion dollar coin option will be an important indication of market psychology.

What about earnings?
As well, don't forget that Earnings Seasons is just starting. David Rosenberg reported last Friday that:
And let's not forget the earnings landscape. So far, we have had 26 S+P 500 companies report and they seem to be meeting their beaten-down targets (indeed, 17 have surpassed their estimates, only six have missed). But of the 11 that have provided guidance, nine have have taken it down and just two have taken it up, for a ratio (albeit on a limited sample size) of 4.5x versus a historical average of 2.0.
While it's still early, an earnings beat rate of 65% (17 of 26) is only slightly ahead of the historical average. On the other hand, the high level of negative guidance is something to be concerned about.

Here is why the forward guidance matters so much. FT Alphaville reported that a New York Fed paper showed that the effects of payroll tax expiry is devastating to consumer spending:

This paper presents new survey evidence on workers’ response to the 2011 payroll tax cuts. While workers intended to spend 10 to 18 percent of their tax-cut income, they reported actually spending 28 to 43 percent of the funds. This is higher than estimates from studies of recent tax cuts, and arguably a consequence of the design of the 2011 tax cuts. The shift to greater consumption than intended is largely unexplained by present-bias or unanticipated shocks, and is likely a consequence of mental accounting.

What's more, analysis from Credit Suisse showed that the payroll tax expiry has taken away all of the net earnings gains of 2012:

That's why it will be critical to watch the body language from forward guidance, especially from companies that are sensitive to consumer spending.

Right now, we are seeing leadership from small and mid-caps in the US, which technicians have pointed to as a sign for being bullish. However, if the American consumer were to falter, then this leadership will start to fading like the morning mist.

My inner investor is very nervous about this stock market. My inner trader is a little bit more sanguine and believes that there could be a bit more upside that he may be able to catch. However, he is tightening up his stops to limit his losses and keeping an eye on the exit.

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.


Gerry Martiniuk said...

EPFR report regarding "equity Fund" investment disputed by equity fund manager on CNN who said only ETF's are up not equity funds which continue their decline in investment.

Gerry martiniuk said...

Fund manager on CNN disputes inflows are into equity funds rather than ETF's.

Anonymous said...

Even on up days, we don't go up that much now. Markets need to correct. At least, we're going sideways though.

What about the coming debt limit/sequester debate crisis coming in a month? Shouldn't markets start to discount the chaos before pricing in a solution later on?