In the category of "Everybody knows that," right behind "15 minutes can save you hundreds on car insurance," is the notion that the bull has prevailed in 2013. After all, the S&P 500 is up 24% year to date as of early November, and all major indexes and sectors are up between 20% and 30% year to date. We all know it, right?
While the rally has come easy in 2013, some big-rally years are a tussle throughout, with a far from certain outcome. 2012, for instance, had a 10% peak-to-trough decline between March and June, and finished with a post-election and pre-fiscal cliff decline that pitched the S&P down through 200-day support in November. By contrast, 2013 has been a smooth ride higher, with just the 5% decline across May and June (barely) disturbing the uptrend.
We see four signs or trends within the 2013 bull leg that made victory almost certain. Two of those trends - increasing retail participation and rising equity fund flows - are familiar and require more documentation than explication. The other two - time above long-term support and placid daily rate of change - are less familiar and will require more explanation.
All four of these trends have been supportive of the bull rally in 2013. Not only that, we'll argue that they set the stage for additional stock appreciation in the coming year.
1) AAII Sentiment
The American Association of Individual Investors (AAII) tracks the bullish, bearish, and neutral sentiment of retail investors, as opposed to institutional investors. Retail investors manage their own money or act as private wealth managers for a network of friends, family and colleagues. These investors are viewed disdainfully by institutional investors, who regard them as a lagging indicator. In past, the "smart" money would treat individual investor sentiment as a contrarian indicator, for instance moving to the sidelines when the "dumb" money got bullish.
That thinking is at least somewhat outdated in the era of internet research and trading resources available to every investor; and retail money can be as deft and nimble as institutional money. AAII sentiment was too bullish late in the 1990s. A smarter and more skeptical generation of retail investors is no longer blindly following the herd. But this group is showing more bullish disposition.
AAII bullish sentiment averages for most of the post-2009 bull market suggest that retail investors have missed much of the rally. We look at annual averages to assess the retail mood across a 52-week span. AAII bullishness, which dropped from 41% for all of 2007 to 34% by 2008 (heavily back-weighted to the autumn months), registered a still-skeptical 37% in 2009; became more bullish at 41% in 2010; but retreated to 38% in 2011 amid policy problems (QE and the European sovereign debt crisis). AAII bullishness stayed down at 37% in 2012, missing out on last year's double-digit gains.
For year to date 2013, bullishness has climbed back to an average 39%. Since mid-year 2013, however, AAII bullish sentiment has averaged a better 41%. Since the begging of September 2013, retail bullish sentiment averaged above 42%. And the October four-week average in AAII bullishness was 45.5%. The trend rather than the absolute number is encouraging.
How high can AAII bullish sentiment go, and does it help sustain rallies? In the peak late-1990s period of the internet bull market, AAII bullishness averaged 41%, with peak readings of 43% in 1996 (smart) and 42% in 1999 (not so smart). Retail sentiment likely kept the internet boom inflated a bit longer than was warranted
Given the rising AAII bullish trend into year-end, we see room for additional retail participation, which would add fuel to the bonfire currently being kindled by institutional, hedge fund, and pension fund money.
2) Equity Mutual Fund Flows
The Investment Company Institute (ICI) tracks flows of funds through a range of mutual funds, including equity only, hybrid (stocks and bonds), and fixed income only. ICI also looks at U.S. (domestic) fund flows as well as international fund flows. ICI fund flows captures some retail activity and even some trading (hedge fund) institutional activity. The lion's share of mutual fund money is in our 401(k)s and other retirement instruments, managed by pension funds and/or company sponsored retirement plans.
The multi-year trend in fund flows, even across this very good bull market, has been disinvestment in stocks and massive investment in bonds. Don't underestimate the demographic component in this trend, as aging baby boomers become more conservative in safeguarding retirement net eggs. Mainly, though, wealth managers were following the path of least resistance: as bond yields came down, down, down in a decade-plus trend, bond prices rose steadily.
From the beginning of 2007 through October 2013, according to ICI data, total bond fund in-flows averaged $13.6 billion. Over the 82 months in that span, total bond inflows were about $1.1 trillion. Meanwhile, average monthly outflows from U.S. equity mutual funds were $7.2 billion. Again over the nearly seven-year period, approximately $593 billion drained out of domestic equity mutual funds. On a total (worldwide) equity basis, monthly outflows since January 2007 have averaged $3.9 billion and totaled $319 billion.
We've included 2013 in our multi-year survey period. But as 2013 progressed, the current-year pattern began to diverge from the multi-year pattern. For 2013 overall, domestic equity inflows have averaged a still-small $500 million monthly. But worldwide equity inflows have surged to $10.9 billion on a monthly basis. At the same time, fund flows have reversed for bonds. Bond funds have averaged a $3.5 billion monthly outflow across 2013. We have not discussed hybrid funds, which have reportedly skewed their mix away from bonds and towards equity.
Even if bonds sustain recent strength after their sharp decline this past spring and summer, we see little room or reason for another meaningful, multi-year bond rally. Once the Fed gets serious about tapering (likely in late spring or early summer 2014, interest rates will resume their climb; bond prices will fall; and exiting fixed-income investors will cycle their money back into stocks, amid a dearth of better choices.
3) Time Above Long-Term Support.
We all know it has been a long and strong rally since March 2009. Typically, extended rallies have their best periods early on. But based on the trend in long-term support now prevailing, it can be argued that the market is currently is the strongest and most prolonged phase of the bull market to date.
We took a look at the 200-day simple moving average, also called the long-term trend line, to see how it has held up in various phases of the bull market. Amid the steady downturn in 2007, the S&P 500 fell below its 200-day SMA in January 2008. After the stock market collapse of Fall 2008 and Spring 2009, the S&P 500 finally got back above the long-term trend line in May 2009 - meaning the index spent 1-1/2 years below the long-term SMA!
In its strongest such stretch to date, the S&P 500 remained above its 200-day from May '09 to May '10, when the aftershocks of Europe's sovereign debt crisis and the Gulf Gusher sent the market down through July. The market then reclaimed its 200 day in September '10, holding it until the the August '11 selloff on the (first) debt ceiling debacle.
The S&P did not get back above its 200-day until January '12, and then held it until October '12 (we are not counting the single-session violation of long-term support that occurred in May '12). By November '12, the S&P 500 had moved back above its 200-day simple moving average.
In mid-November of this year, the current period of time above long-term support will surpass May '09-May '10 as the longest such stretch in the bull market since March 2009. And there is little reason to assume the market will end this stretch anytime soon.
First, the S&P 500 is about 140 points above its 200-day simple moving average trend line. From current levels of 1750-1760 on the S&P 500, it would take a 6%-7% decline to get the index below its 200-day. While some year-end profit taking is possible, the market is highly unlikely to give back a huge swath of gains before year-end, short of some year-end secular catastrophe, as long as repentant bears are chasing the rally and trying to make-right clients' money. Second, earlier failures at the 200-day SMA during the current bull market have generally occurred in mid-summer, when the market is at its most vulnerable. By contrast, we are now in the strongest part of the stock market calendar.
All systems are go for a continued rally into year-end. As we begin 2014, long-term support should still be well above the trend line and ready to lend emergency support in any significant downdraft.
4) Placid Daily Rate of Change
The year 2013 is shaping up as a sleepy one in terms of trading. With nearly ten months gone in the year to date, the daily change in the S&P 500 has averaged 0.58%. We measure daily rate of change by squaring the daily change between two adjacent sessions, deriving square root of that number, and averaging the now all-positive values. This eliminates the muting effect of some days being up and some being down.
The quiet trend in daily rate of change in 2013 follows another relatively sleepy year in 2012, in which the average rate of daily change was 0.59%. Why does this matter? Low average daily rate of change in a single-direction (in this case) rising market means the market is quietly grinding (in this case) higher, rather than lurching in every direction. In 2012 and 2013, the S&P 500 has appreciated 14% and 23%, respectively. If the market had sustained meaningful downswings in the most recent two-year period, much higher average daily rate of change would have been required to pull the market back up to its current winning levels.
The 2012-13 period shows the bull triumphant, but it is not always like that. In markets in which bulls and bears fiercely contest direction, the daily rate of change tends to be much higher. Between 2008 and 2011, the daily rate of change averaged 1.22%, or more than twice the 2012-2013 rate.
Most remarkable was 2010, when daily rate of change averaged 1.04% - even though the market barely budged. Usually, high daily rates of change are associated with single-direction markets, such as the 1.74% daily average change in 2008 (S&P 500 down 39%) or the 1.24% daily average change recorded in 2009 (S&P 500 up 24%).
Another sign that 2013 is remarkably quiet is the relative paucity of 1%-plus-or-minus change days. For 2013, 1%-plus winners (18 to date) don't even have that much of an edge over 1%-plus losers (14 to date). This trend, too, is now favoring bulls. Since August, 1%-plus winning days on the S&P 500 have outnumbered 1%-plus losers by 5-to-1.
All told, markets that don't have huge downswings often do not have the corollary event: huge and frothy upswings that invite complacency and eventually profit-taking. Bears can claw away at thin and ill-supported market spikes. It is much more difficult for bears to tear down an advance that is broad and well-supported and (that word again) quiet.
Every year is a new start. In market terms that often means that last year's losing groups cycle to the forefront, and winning asset classes sometimes find themselves in the lower quadrant. That said, we see four reasons why bullish stock trends could carry into 2014. We have not even mentioned economic or earnings fundamentals, which we also see in a positive light.
In summary, and putting aside the economy and earnings, these four drivers provide optimism for the market entering 2014. Retail investors have barely begun to move into the stock market, but that trend is accelerating. And, after the great bond investment and stock divestment in mutual funds over the past six years, the direction of flows has reversed. Stocks at present are showing their most durable support of any period in the bull market since spring 2009. And bears simply can't get their claws into this market, judging by the quiet grind higher in equities in the past two years.
(Jim Kelleher, CFA, Director of Research)