Sunday, August 17, 2014

Onwards and upwards

Weekly Trend Model signal
Trend Model signal: Risk-off
Direction of last change: Positive

The real-time (not back-tested) signals of the Trend Model is shown in the chart below:

Stay long the bounce
Last week, I showed this chart and pointed out that combination of the VIX term structure exiting inversion and TRIN falling from an 2.0 oversold condition was a powerful signal for an oversold rally (see A tradable bottom?). In the last two years, this combination has had a perfect record of calling bounces, which have lasted a minimum of two weeks.

My opinion hasn't changed. I continue believe that the odds favor a continued rally to test the old highs seen in the SPX. Initially, I was somewhat concerned that both the slope of the term structure of the VIX and the VIX Index itself was falling very quickly. This was leading very quickly to a short-term overbought condition. As the chart below shows, such behavior is typical of oversold rallies when the VIX term structure exits an inversion (dotted vertical lines) and bulls should not be concerned about the rapidity of the improvement in these indicators.

Rob Hanna at Quantifiable Edges confirmed the conclusion of my analysis when he conducted a study of what happens when the VIX Index moves from overbought to oversold very quickly. Though the sample size is relatively small at 18, it does show that the market still has a bullish tailwind at its back under such circumstances. Note that he posted this last Thursday, which meant that his analysis was based on Wednesday`s closing prices:

Panic is still in the air
Despite some technical concerns, such as the inability of the SP 500 to overcome its technical resistance at the 50 day moving average and the lagging performance of high-beta small cap stocks, the sentiment picture remains supportive of further advances.

I have written that I tend to be somewhat skeptical of the results of sentiment surveys as sentiment readings can bounce around because they reflect opinions, rather than what people are actually doing with their money. I therefore tend to watch sentiment data that indicate how market participants are actually betting. In this respect, the ISEE Index, which is a call-put ratio of opening customer option transactions, is a good reflection of short-term market sentiment. As the chart below shows, the equity-only ISEE Index remains low by historical standards, indicating few bullish call buyers, which is contrarian bullish.

As well, it seems that institutional investors have panicked as stock prices tanked the the past few weeks. I was initially skeptical of the NAAIM readings and questioned the sampling techniques and methodology of the survey. The chart below shows that the equity exposure of NAAIM institutional investors collapsed two weeks ago and they remained low in the latest weekly survey results.

These readings were confirmed by the results of the BoAML Fund Manager survey, which showed that cash holdings spiked from 4.6% to 5.1% last month and fund managers had rushed to buy tail-risk protection for their portfolios.

By contrast, the latest chart from Barron's indicate that insider activity is supportive of the bull case:
The weight of the evidence therefore suggests that market participants have already panicked. Bear markets and deep corrective market action generally do not start with sentiment readings at such bearish levels. Barring some catastrophic event, I expect the oversold rally to continue for at least another week, when we can look forward to possible hints of new directions in Federal Reserve policy at the annual Jackson Hole meeting.

IHS upside breakout
From a short-term technical perspective, the SPX appears to have staged an upside breakout from an inverse head and shoulders (IHS) formation. The Ukraine tension related pullback Friday saw the index retreat to successfully test the neckline of the breakout. The measured target of the IHS is 1985, which is roughly a test of the old highs in the index.

"Lack of a bear case for stocks"
Should I be correct and the SPX rallies to the 1985 target or test the all-time highs, what happens next?

To answer that question, I turn to an analysis of market fundamentals, which continue to tilt bullishly and remain supportive of further advances. Last week, Morgan Stanley published a report indicating that they saw little downside for equity prices for now as there was the "lack of a bear case for stocks" (via Marketwatch):
Here’s one reason why this stock market isn’t going to truly slump any time soon, according to Morgan Stanley analysts: “The lack of a credible bear case.”

The analysts, in a report published Monday, say the top of the market is defined by hubris and debt, and argue neither is present at the moment. Instead, it’s hard to argue that costs — whether as capital spending, inventory or hiring — are rising enough yet to be a threat to profit levels, they say.
They concluded (emphasis added):
They’re back to bullish view in the wake of the market’s recent pullback, after having gone to “balanced” on a 12-month forward view last month. The analysts say stock-market valuations could still expand strongly because the economy is improving, real yields are higher (and inflation is low), and Fed policy is still accommodative.
In an interview with Barron's, Stephen Auth of Federated Investors summed up the bulls' view this way:
As a way to describe the economy, Goldilocks was formulated back in the 1990s, when the Fed was relatively well behaved and the economy was expanding. Today, I call it "Goldilocks cubed" because we have what actually may be an accelerating economy, with the Fed and Treasury rates well-behaved and perceptions about risk declining. Market valuations depend on growth, bond rates, and perceptions of risk, and all three of those are going in the direction that actually expands the price/earnings multiple. At the same time, earnings are expanding, and that's a recipe for another leg up in the market. In terms of economic expansion, we have been stuck in this 2% growth range since 2008-09. But we think something has happened and that animal spirits have returned. We've had these sky-is-falling moments, and every time we get through one of them, more and more people come out of their caves and say, "Maybe the sky is not really going to fall."
In other words, the stock market is in a sweet spot right now. Economic and EPS growth look good, the interest rate environment is benign and risk appetite is healthy.

While my views are tilted bullishly, that does not mean that there is nothing but clear sailing ahead for stocks. The direction of change of the Trend Model is positive, which is bullish, but the absolute level of the reading remains in "risk off" territory, which brings up the possibility that the current rally is a counter-trend rally in a downtrend. I will detail some of my concerns for US equities in a later post this week and tweet any updates as I see them at @humblestudent. You can also subscribe to my blog posts by email here.

Disclosure: Long TNA, SOXL

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