By now, everyone is sick of hearing all the so-called experts in the financial media saying that we are in for a 5% or 10% correction. In any case that one looks at about making a market timing call, it has all been a bunch of talk with no supporting evidence. I am not here to make a market timing call but better yet to make a trend call based on a fundamental, technical and quantitative perspective. Now more than ever, it is imperative to look at not only what is driving a market higher via corporate earnings, but also what the psychology of those investors and traders who put big money to work is, and how they feel about the broad market as a whole. To do this, we have to look at market color and flow dynamics in the S&P options pits to see what the smart money is trading and what they expect.
Valuations, while not dirt cheap, are more attractive now than in 2007. The DJIA's trailing P/E is 15.5 versus 16.9, and its dividend yield has climbed from 2.1% to 2.5% while the S&P 500 having a P/E of around 14.5 with a dividend yield of around 2%. The upshot is that after the noise fades and the correction that is not only possible, but imminent, comes, as long as demand for stocks is rising, the cyclical uptrend should remain intact.
From a macroeconomic view, the situation is looking better, but not at the level that anyone was expecting after being in the trenches for five years, and slowly getting back to the levels in the S&P 500 that we once saw at the end of 2007. While many look at unemployment, as a lagging indicator, it is a great leading sign of things to come in the forward indicators. With that in mind, by looking at certain data we can interpret from a broad overview of what the economy currently looks like. We start with housing and see that housing starts are going up, GDP is growing, and with consumption being 70% of GDP, retail sales should only be doing better. Real disposable income had been sharply up posting a modest decline recently, but back on its upward trend. Initial claims are also signaling that either people have found work or have just given up looking. All signs currently point to more people have found work than those who dropped out looking. And, for all those who say that banks aren't lending, just take a look at commercial and industrial loans at commercial banks that are rising. Overall, if you compare where we were back in 2009 to present it seems that the U.S. economy has made tremendous progress. However, it is by far from being complete picture as we still have an issue with consistency in data being reported, but are making tremendous strides. Below are charts describing the economic data discussed.
All Charts Courtesy of FRED: St. Louis Fed
While the fundamentals look favorable for the longer term, the shorter term story paints a different picture. From a technical perspective, we are seeing an almost picture perfect Elliot Wave chart where we have just finished a strong run up in the SPY, and are looking towards the tip of that run. For those unfamiliar with the Elliot Wave principal, it is a fantastic trend following "wave structure" that measures the psychology of the market and can be best applied to any liquid asset class. It has a 5 wave sequence which are called impulse waves and a 3 wave sequence which are the corrective waves. Waves 1, 3 and 5 are bullish (or bearish depending on the trend) waves which are also called motive waves while waves 2 and 4 are the waves that exhibit prices corrections which are called corrective waves. A great chart technique to combine with the Elliot Wave principal are the Cloud Charts that are fantastic for having a quick look at bullish or bearish zones. If price is above the cloud it is bullish and if below the cloud it is bearish. If price is in the cloud then it depends on whether it came from above the cloud and now is into the cloud (bullish) or came from below the cloud and now into the cloud (bearish). They are also helpful in giving forward looking guidance as the clouds tend to extend beyond the current price action.
In analyzing current price action, we have a price that is above the cloud, which is bullish, but also nearing the end of wave 3, which means a correction down to wave 4 is imminent. Wave 3 is usually (not always) the strongest wave where you get the strongest price action. Wave 5 is usually considered an exhaustion wave meaning that the rally (if in an uptrend) or decline (in a downtrend) is near its end and the trend is about to change sometime soon. Wave 3 does not always have to be the longest but can never be the shortest when compared to Waves 1 and 5. As of now we are currently in a strong up trend but looking for a modest pull back to wave 4 which can be expected around the 152.50 range before heading higher again.
In terms of price targets, we take a look at the point and figure charts which can give us a very good view of pure price action by eliminating the noise caused from frivolous movements or fast reactions to news within the markets.
At first glance, a reader will first see how different the two charts really are. The key here is know and understanding that Elliot Wave interpret market psychology, and the movement of market participants to get a wave count that will include noise. With point and figure it is a much different story in that the charts only move from a box size that is set by the chartist and a reversal count that is also set by the chartist to know when a trend will reverse. Hence, when optimized properly it can give very good buy and sell signals not to mention very reliable price targets. Analyzing the chart above, the box size and reversal are 1 x 3 meaning that for the current trend to continue, price needs to move up by one point or reverse by three points for the opposite viewpoint. For every one point move in SPY will cause another "x" to be made on the chart. For every 3 points move down will cause an "o" to be drawn on the charts hence, a reversal. The 45 degree red lines are trend lines that can also act as support and resistance depending on how someone wants to look at the chart.
In analyzing the above chart we see that currently price being at around 156.50 that the next upside target is at 158. While the price action is running on fumes with smaller rallies and declines along with smaller volume (as shown below in the flows section) it can be seen that price action has been stuck there for sometime as price on the point and figure chart only moves up every 1 point as directed by the box size here. The nearest trend line also has support of around 151-152, hence, where wave 4 on the Elliot Wave count would be around 152.5. Although both charts tell two very different stories, it is nice to have some confirmation of where price could retrace.
Now, combining both the point and figure and cloud charts we get a bullish picture of price being above the cloud, and with bullish price targets. As stated before cloud charts can have a forward looking mentality and that can be seen from the cloud that goes beyond the price action (look to the right of the chart in the blue upward moving cloud). In this case, although we are expecting a modest pull back, the longer term trend does look bullish.
Market Color and Flows:
From a fundamental perspective we get to see what companies generate in terms of revenue, expenses and earnings per share from a simplistic point of view. From a technical perspective we get to see how investors and traders view companies from a psychological point of view and what the near term price action could bring. From a market color and flow perspective we go inside the market to observe the investing and trading flows and drill down into what exactly is being bought and sold and where the big money is going.
First, below we have the daily option flow or the S&P 500 options floor. It covers the month of March but shows signs of what is possibly coming. It shows that there were more puts than calls traded, and that the higher volume was traded well before any earnings releases. Flow activity like this can be a sign of what is to come if traders are feeling pessimistic for the short run earnings cycle.
Courtesy of Whatstrading.com
Next, is a chart of the VIX trading activity which is a measure of the volatility index of the S&P 500. Again, a very telling sign that volatility positions are being put on right before the end of the quarter. It can be interpreted as possibly signaling fear to come in the broad market. As of recent, trading has calmed down tremendously with option flow now below its normal trading volume.
Courtesy of Whatstrading.com
Whether you believe markets from a longer term fundamental outlook, short term technical patterns or from a market color and flow trading point of view, there are a couple of things to keep in mind. First, markets are moving higher with lower volume. One of the biggest telling signs of any market top is when you have more 52 week highs than 52 week lows but on lower volume. Second, more put activity on the S&P 500 options following by increased call volume on the VIX. Third, from a relative value fundamental stand point companies have more cash on hand, product lines in certain industries are expanding and that the P/E of the broad market and most sectors are still fairly priced. However, nothing goes up in a straight line and it helps to have caution when necessary. I hope the above analysis did a good job in painting a picture with enough evidence about where the market stands from both a short term and longer term perspective, and what we can expect going forward. Also, it is helpful to know that "sell in May and go away" is right around the corner.