From April through May, I published a series of articles advocating the purchase of U.S. equity market puts. My initial position was established April 11th, with the roughly 3/4s of it being closed out one week later. It was my best trade to date. My timing was initially impeccable; however it was also extremely short-lived. From there it became an exercise in poor risk management as gains became losses as I added to the position on successive moves up. I blindly discarded stops I had set, and rather than having a great trade on the recent pullback, it turned out to be just a mediocre one overall.
In retrospect, the strong move through 1600 in the S&P 500 (SPY) should have been a clear sign to reduce or temporarily close my short exposure. Trading is always easy in retrospect, but such is life. Clearly I anchored myself to my original outlook, and in part because I was studying for CMT and CFA level 3 exams, I didn't have the time or clarity of mind to really think things through. The earliest options I bought were June 22s, so time was on my side (this was my excuse, a poor one and one that I don't intend on repeating).
Fortunately for me, by far the largest position I established was on May 28th near the close, and the majority of my other puts became profitable again. My basis for a full on short was the result of multiple analysis, but most importantly, price action had become overwhelmingly bearish for the near term. The 1675 level failed on four different days, and there was a major "blow-off" top on May 22nd.
The following will examine some of the ongoing arguments that I have considered to date and ones that suggest investors should be skeptical of any near-term equity market bounces. As of close today (June 5th), I don't have an opinion (or position) on near-term direction, but remain bearish longer-term. That being said, I may initiate both long- and short-term positions as my time frame can vary.
Broad Market and Global Themes
Japan - The Driving Factor
Japan is largely in focus, and while still notably in an uptrend, the Nikkei has endured much pain recently. As it has led global equity markets up since November 2012, it has been a critical component of the recent 6-month rally. That rally hit a massive wall of resistance on May 23, and 16000 will likely serve as a pivotal level that needs to be broken for a long-term rally to be considered under way again. The below chart puts the longer term trend in perspective (it is dated by about two weeks).
Volatility - Increasingly in Focus
In comparison to volatility experienced in commodities and currencies, equity market volatility has actually been quite tame to date. Some have argued that increasing volatility lately has been bullish for equities which I believe to be quite ridiculous. Sure, in the context of the current equity market rally (the most impressive in the Dow on many accounts), the spikes year to date have been great buying opportunities. But there still has not been a meaningful move in volatility that warrants a definitive correction call. All signs suggest one is coming in my opinion, but as noted in the chart below, until a meaningful new high in the VIX (VXX) is experienced (a close above 18-19), a longer-term correction shouldn't be considered present. The blue circles below represent increased volatility where the trend of lower highs was broken and a meaningful correction was experienced. So yes, small spikes in volatility can be bullish for equities, but large spikes certainly are not.
The Aussie - Oi Oi Oi, or Ow Ow Ow???
The Aussie dollar (FXA) is something that warrants ongoing analysis as it has recently has taken on some serious pain. A commodity driven currency, its proximity to China provides a good indication of global growth. The race to devalue currencies is also a consideration now as much as ever, but the recent break down in the $AUD is certainly not bullish for global growth or equities. Note the high correlation of the $AUD and the S&P 500 below. While the $AUD lagged equities in 2008, it could in fact be leading now. This is only speculation, but after consolidating for a year above 102, one should consider the implications of a further move down.
On the topic of China (FXI), I think a year to date comparison to the S&P should raise caution (Further global divergences are examined later in this article)
Margin Debt - Repeat of 2000 and 2007 levels
There are a plethora of sentiment indicators one can analyze. Margin debt is one of the best; it measures how leveraged people actually are, as opposed to their thoughts, outlook or opinion. Extreme readings were reached in May, and such extremes have not typically forecast bullish price action.
Macro Economic Relationships
Silver To Gold, Greater Divergence = Greater Importance
The 150 week correlation of the silver (SLV) to gold (GLD) ratio and the S&P recently went negative for the first time since 2000. This ratio is a longer-term indicator, but as it is a measure of the strength of the economy (silver has more industrial uses than gold), it often can lead major equity market moves. The three lowest correlations are highlighted below, as are the corresponding divergences.
I will note that there were smaller divergences in 2005 and 2010 that converged with the ratio moving up rather than equities moving down. The larger divergences, however, have been reliable.
A relationship that I have been monitoring over the last few weeks are the high yielding (HYG) or Junk (JNK) bonds. These bonds can often lead equities and are considered more equity-like due to their higher risk than most bonds. There have been stark similarities in price action to that experienced in 2011. Note a very tight, complacent trend in the price action and the RSI that eventually gets completely blown out. The break of this trend in 2011 led to a volatile correction in junk bonds and accordingly equities.
GDP and Output
GDP and various output composites continue to show limited growth. Trying to trade the economy or macro trends rather than the S&P or market indices can be difficult as they can diverge, but in the long run there needs to be convergence between the economy and stock market indices.
Non-farm and Unemployment
Wednesday's ADP report was seen as a miss for most and a sign of slowing growth; the consensus expectation was for 165k but 135k was the print. While it could be a reason for further QE, there has been a clear downtrend.
And while the unemployment rate continues to retreat, so too does the labor force participation rate.
I would suggest that the interpretation from non-farm and unemployment should be "mixed". Do they fundamentally support recent nominal highs in equities? Probably not, but the divergence could continue to be dwarfed by the QE argument in the short run. In the long run I would suggest however that continued slowing of non-farm private employment growth and lower labor force participation rates would eventually weigh on equities.
The inflation argument, that central banks around the world can inflate their way out of current problems, is one that I have a problem with. Perhaps it is due to my nominal knowledge in the area, but the below charts don't exactly support the QE argument. It seems like deflation is still the bigger concern, and deflation has never been bullish for equities.
Inflation clearly hasn't been experienced in commodities, and until the below trend line in the CRB is broken, I remain skeptical.
That being said, there obviously were some positive results so far with Japan's QE attempts, and there has been a positive correlation with all the various U.S. QE programs and rising equity prices. My comments on QE and inflation are brief, and it is not my intention to understate the importance QE has played and will continue to have on equities. It is simply an area I am not yet too knowledgeable about and can't make further comment on.
I have made the case a few times recently that the S&P was beginning to appear parabolic. I wouldn't suggest that it truly was parabolic, but price action certainly has had many parabolic ingredients: increasing trend, decreasing corrections, blow-off top and reversal, unsustainable momentum, etc…
A blow-off top is often characterized by extreme levels of buying climaxes (a new 52 week high that ends up closing down on the week). The last week of May presented such an extreme:
The 1675 level in the S&P that I sold against corresponded with a very important psychological level of 1000 in the Russel 2000 (IWM). For four days this level was breached intraday, but not once could it close above. For any technicians this was an extremely important rejection at a key level.
Such resistance at 1000 has not been unprecedented. As Ryan Detrick noted on May 22nd,
The S&P 400 MidCap (MID) first touched 1,000 in April 2011. It didn't fully clear this level until this past December. That is nearly 20 months for those scoring at home. The Dow is even more amazing. It first hit 1,000 in January 1966 and didn't fully clear this area until late 1982. In other words, it took more than 16 years!
Much has been discussed about housing leading the continued equity market rally. Well what leads housing? Lumber leads housing. It led housing and consequently equities down in 2007/2008, and most recently had an incredible sell-off and long-term break of trend.
Just about any global comparison of the S&P shows a massive divergence; be it in a 3-month time frame, 6-month etc… Of particular interest to me are "The Americas" - the U.S.' closest trading partners - Mexico (EWW), Canada (EWC), and Brazil (EWZ). Some have argued the divergence has been the result of a strong $USD (UUP). This argument is fundamentally sound and somewhat explanatory (as is the inverse; the commodity component), but over the last three months the $USD has been flat while the divergence continued. Below is a 6-month charts of "The Americas" (black), the S&P (red), and the $USD (green).
Anyone who argues that we have entered a new secular bull market is just flat out wrong in my opinion. Prices are still well off inflation adjusted highs, not to mention nominal highs in the Nasdaq. This is subject to change, but at present, the secular bear is still intact. It would be much more plausible to suggest that we are likely entering the later stages of a secular bear (note the below chart is one year old, but still indicative of the current secular bear).
One chart that may be leading a future secular shift is the Dow (DIA) to Gold ratio. Until 2000, this ratio consistently went up and indicated one should be in stocks rather than gold (it is also indicative of cycles between hard and soft assets in general). That changed in 2001, and the ratio clearly indicated a secular shift into gold from stocks. This has probably been one of the most profitable indicators of past generations.
The 2013 break of trend shows yet another reversal now favoring equities again. Like any indicator, it should never be considered in isolation. It could very likely reverse here and form more of a base, it could also continue to extend upwards. In any case, it provided excellent long-term signals in the past and should be monitored as one tries to determine the rotation of secular trends.
S&P 1600 (1590 - 1610) was my established price target on May 28th, and I am now personally all in cash. It wasn't an approach I suggest to others (averaging in, holding losers) and it is something I plan on reflecting upon now that I have some time. Many mistakes were made on my behalf that need further thought.
From here equities could certainly continue down, but in the short term they could certainly bounce up. To be honest, I would not advocate any new position at this juncture. Corrections typically take longer to occur, and I would expect a bounce at some point prior to another major move down if a correction were to take place. Longs could be nimbled into if these levels hold, but I would be nervous being long if/when new highs are made in the VIX.
As of this point I imagine I personally would sell any bounces, but that is the same thought I had in April which proved to be difficult. Accordingly, for it me it is time for further market and trading analysis (I intend on writing a second article shortly examining some of the shorter term indicators examined in my past articles as well as major mental errors I made).
Most of the evidence presented in this article is bearish both short- and longer-term, but more so long-term. That being said, the long term trend is still definitively up and should be respected. As I painfully realised in April and May, prices can continue up despite what one may consider an overwhelming amount of bearish evidence. The trend is your friend, and this is the most important rule to respect in trading or investing. The chart presented earlier showing that the S&P had parabolic features could continue up in its previous "parabolic" trend. A failure to break through or even close the May 3rd price gap in U.S. equity markets would definitely be bullish near-term.
Further, all relationships and analysis are not static and need to be monitored on a continuous basis. What is bearish today may reverse and prove to be bullish tomorrow. The best analysts, traders, and fund managers develop an outlook but don't anchor themselves to it. One must always be willing to give reasonable consideration to new information.
Japan should be kept in focus, and so should volatility. While small increases in volatility can produce attractive buying opportunities, larger increases should be approached with caution.
The most well-known cycles (seasonal, presidential, and secular) are all currently bearish. Cycles are not definitive, but they are well known for a reason. Being irrationally exuberant in past secular and seasonal bear markets in particular has not paid well.
Whether global growth is continuing apace or slowing can be argued, but I think one can confidently say global growth is not matching equity market returns. The question becomes: what is more important, growth metrics or QE programs? To this question I don't have an answer and is an area I personally plan on spending more time on.
Please keep in mind I publish articles on SA for perspective. While I have a fair bit of education and experience, I do not consider myself an expert. I have made many mistakes recently, will likely make many more, and have much to learn.