The S&P 500 has been on quite a run this year with it climbing almost 17% year to date. Currently, the market has sold off modestly from an all time high of 1709 on August 2 to its current level of 1632 at Friday's close. Given recent developments in market conditions, I believe there is an excellent opportunity on the long side with limited risk.
In a previous article on August 14, I presented my reasons for taking some profits on long positions. From that point, the market dropped slightly with more concentrated selling pressure in interest rate sensitive sectors. However based on some constructive developments detailed in this article, I see fit to alter my stance.
Underperforming Fund Managers
There are two conflicting dynamics in the market, and it is fascinating to see the interplay between them. On one hand, margin debt levels are at staggering levels that have corresponded to previous tops in the market.
My takeaway is that if selling pressure does materialize, there is the risk of a cascading sell-off as traders are forced to liquidate positions to meet margin levels, potentially exacerbating any sell-off. Therefore, when market conditions turn bearish, I am more inclined to reduce exposure. In less frothy conditions, I would be more willing to ride out weaker market conditions.
The competing bullish dynamic which in the short term has overwhelmed the warning sign emanating from margin debt is the underperforming fund manager. More times than not, the fund managers are the ones who move the market, at least in the short term. Currently, they are being trounced by the S&P 500 which is their benchmark.
A weakening stock market would be manna for these funds and the worst case scenario for them would be for the market to continue its current pattern of grinding higher with shallow dips. I believe this is very bullish for the market that the "pain" trade continues to be higher, as this group remains painfully underexposed. Instead, it is possible that moves to the upside are exaggerated as these funds "capitulate" to make up for their underperformance, pushing the market even higher.
Momentum and High Beta Stocks
Although I don't really trade the momentum and high beta stocks, I follow them closely partially for the entertainment value but primarily because it is revealing of the "animal spirits" in the market. These are stocks like Tesla (TSLA) Netflix (NFLX) Priceline (PCLN) LinkedIn (LNKD) and Yelp (YELP) to pick a few. As long as they are going up, they delight their shareholders and frustrate value investors.
These stocks typically trade at high multiples with high expectations for future corporate performance, typically when they do top, the corrections can be quite drastic as they give up a huge portion of their overall gains. On the other hand, fund managers are apt to pile into these liquid stocks as they are likely to outperform the market in some ways creating a self fulfilling prophesy.
Therefore, I have been closely watching the performance of these stocks as the market goes through this selling phase. For me, to believe that the bear case has legs would entail these stocks to show signs of distribution. Instead, the share prices continue to be supported with only minor sell-offs as seen in the charts below:
Although, I have chosen these 5 because they are leaders in this market, most of the momentum stocks I follow are giving more signs of accumulation in a weak market rather than distribution. And almost all of them are maintaining their pattern of higher lows and higher lows. My conclusion from these stocks is that "animal spirits" remain alive and well in the market. The time for these to be extinguished is during a selling phase in the market, as overleveraged players begin to liquidate positions. The absence of distribution in these frothy names makes me more inclined to start looking for opportunities on the long side.
Another bullish development is that market internals remain strong. To support my bearish tilt, I was looking for signs of distribution in more vulnerable and leveraged sectors such as small caps and cyclical stocks. However during this selling phase, these have performed admirably, adding to evidence that the market remains under accumulation.
The relative stability of these "risk on/off" indicators especially during this period of market weakness is a very positive sign for the stock market. These tend to be very high beta and another reflection of risk appetites. My interpretation of their behavior is that this mini correction is yet again another opportunity to add stocks.
The concerns which I noted in my previous article still persist, and this little selling pressure has by no means addressed imbalances in sentiment and debt. Prior drops in the market have coincided with these levels, so some more vigilance should be paid towards managing downside risk. A close below 1600 on the S&P 500 would invalidate this bullish thesis and a close below 1550 would invalidate the pattern of higher lows comprising this strong uptrend since November 2012.
Overall, I believe that the market is presenting us with an attractive risk/reward at these levels. There is very little sign of distribution in the market, and I think it is a bullish development that the market has held up quite well given the bullish sentiment and margin levels. Additionally, there were signs of accumulation in sectors that serve as measures of risk appetite such as momentum stocks, small cap stocks, and cyclical stocks. When the trend is ready to change, I am certain these sectors will be leading us lower.