Monday, January 7, 2013

Headwinds for the bull case

I called for a Santa Claus rally in late November (see Waiting for a Santa Claus rally) and equity markets cooperated and prices have moved up strongly since then. Now that Santa Claus has come and gone and we have seen the "fiscal cliff" relief rally, what's next?

Technically, there are a lot of reasons for stocks to at least pause at these levels. The SPX is now testing an important resistance level.

More comforting for the bulls is the broader NYSE Composite has managed to stage an upside breakout through resistance, indicating that the underlying strength is broad and deep.

However, I don't expect that the SPX will break through to new highs in the short run for several reasons. Simply put, this bull is getting tired and this latest up move is facing too many headwinds. First of all, the SPY to TLT ratio as a measure of the risk-on/risk-off trade is also testing a relative resistance level and showing a near overbought reading where stocks have retreated in the past.

In addition, the VIX Index has retreated to a major support zone where it has bounced off in the past. The CBOE noted that the VIX saw its largest percentage move since inception (h/t Global Macro Monitor), which is another sign of an oversold condition for the VIX and overbought condition for equities. In order for the stock market to advance, volatility would have to fall through a major support level.

Last but not least, the bulls have to contend with the seasonal patterns seen in past Presidential cycles. As the chart below from the Chart of the Day shows, the opening week of the first year of a presidential term starts with a rally, which we have seen right on schedule, and the market starts a broad decline into February. So far, the stock market's behavior in 2013 is consistent with this historical pattern.

Watch this Earnings Season!
In addition, Earnings Season will be a source of volatility for stocks. Barry Ritholz warned about an "earnings cliff" and Q4 earnings will be an important test of his thesis. I explained before (see What happens after the Santa Claus rally?) that the "earnings cliff" is the result of a deteriorating profit outlook by large cap multi-national companies. In that context, the outperformance of the NYSE Composite, which is more reflective of small and mid cap stocks, is consistent with that thesis.

Jeff Miller over at A Dash of Insight has an excellent post where he discussed earnings expectations and concluded that this Earnings Season could be pivotal to stocks:
For the upcoming earnings season I remain open-minded and I will be very attentive. Last quarter was a minefield for corporations. If the complete story -- earnings, revenue, outlook -- was not perfect, the stock price moved lower. I avoided earnings dates in our most aggressive trading programs, and I was nearly always right.

So what now? We all know that the economy remained sluggish in Q4, so earnings will not be great. Much of the uncertainty has been lifted. We know the election result and also tax policy for the near future. Will companies provide a little more guidance? What will it be?

I have more respect for the analyst updates than I do for the pontificating pundits with opinions but absolutely no record. I understand that analysts are too bullish in their multi-year forecasts -- basically following trends with no allowance for bad news. I also understand that by the time earnings are actually reported, the bar has been lowered so that more than 60% of companies beat expectations.

Most experts share these views, but I seem to be alone in drawing the logical conclusion:

If estimates are too bullish in the long run and too bearish at the time of the report, there must have been a "crossover date" when the forecasts were pretty good. My research shows that this occurs at about one year in advance.

To summarize: This earnings season will be important for estimate revisions as well as the current "beat rate."
In short, the bull case is facing too many technical and fundamental headwinds to see the market advance too much further in the short-term. I believe that we are likely to see a pullback at these levels. The bulls will have to watch how the market behaves in response to news, such as the upcoming Earnings Season and the political posturing that is likely to occur over the Debt Ceiling, in order to discern the likely direction of the next major move.

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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