A Novel Idea: Sell U.S. Stocks Into Strength

| About: SPDR S&P (SPY)


The red-hot U.S. equity market has not seen any meaningful pull-back since 2011.

The recent sell-off in leading US cyclical stocks is particularly interesting given the coincident rebound in risky EM stocks.

We present three arguments in favor of getting out of US stocks during the current bounce back.

The pull-back in cyclical stocks since mid-March is giving rise to another strong bounce back. Since Q4 2011, the average peak-to-trough pull-back on the Dow has been roughly -6%, with no correction exceeding -10%. One may ascertain that a "buy-on-the-dip" mentality remains pervasive among U.S. equity investors. Indeed, the recent three-week correction, led by biotech and internet stocks, was abruptly halted last Tuesday (April 15) by a powerful inter-day reversal occurring just as the Nasdaq Composite tested its 200-day moving average, provoking the sharp weekly rebound.

So why not add to long, risk-on positions once again? Could this pull-back be different? Aren't stocks "the only game in town" with the excessively accommodative Fed monetary policy?

We offer three reasons why this rebound maybe the one to sell into.

First, our WMA composite risk indicator shown below is giving a very bearish warning. This proprietary risk measure, geometrically links twenty risk-on/risk-off relative index pairs, including the S&P Consumer Discretionary vs. S&P Consumer Staples ; DJ Internet vs. S&P Utilities ; DJ UBS Industrial Metals vs. S&P GSCI Precious Metals ; or the Australian Dollar vs. Japanese Yen. This indicator has correctly called the prior three major equity market downturns: the 2000-2002 tech bubble bust, the 2007-2008 financial crisis collapse, and the 2011 European Sovereign debt and U.S. credit downgrade. As shown in the chart, preceding each of these major market moves, our risk indicator had both established lower highs and lower lows and formed a negative divergence with the MSCI World index (black arrows). For the first time since 2011, the indicator failed to make a new high in March and just posted a Failure Swing, establishing a lower low.

Second, this increased perception of market risk is coming at a seasonally favorable period for the bears. The old adage "Sell in May and Go Away", warning investors of a seasonal decline in equities, is often attributed to summer vacations and decreased investment flows relative to winter months. According to the Stock Trader's Almanac, since 1950, the Dow Jones Industrial Average has had an average return of only 0.3% during the May-October period, compared with an average gain of 7.5% during the November-April period. We look at the performance of the S&P500 during the May-October period in the chart below. Of the 13 cases since 2001, the strategy of selling out just before May would have given rise to successful trades in 9 cases, or about 70 % of the time. Moreover, we observe that the "Sell in May" strategy has not failed in two consecutive years since 1992-1993. Given that "Sell in May" failed in 2013, we estimate the odds for a seasonal decline are even higher for 2014.

The relative attractiveness of foreign stocks versus U.S. stocks at current levels constitutes our third reason to rotate out of U.S. equities on any strength over the coming days. We consider both the absolute price spreads and the sentiment extremes. The current relative valuations of U.S. stocks versus foreign stocks stand at multi-year highs, and are, in our opinion, rather exaggerated versus emerging market stocks in particular. As technical analysts, we give less credence to fundamental valuation metrics such as P/Es, as stocks tend to remain over/under-valued longer than anyone would expect. Nevertheless, at 18 times forward earnings for the S&P 500 and 36 times forward earnings for the Nasdaq, U.S. stocks are generally closer to the high end of their range while at 12 times forward earnings, the P/E of the MSCI Emerging Markets Index is closer to the low end of its range. More interesting today is the historical price spread between U.S. stocks and emerging market stocks. The next chart shows the price spread between the S&P 500 and the MSCI Emerging Market Index since 1998. The last periods of significant outperformance of U.S. stocks versus emerging stocks date from the tech bubble in 1997-2000 and the financial crisis in 2008. The dominant trend, we would argue, is reflected by the period 2000-2011 (in spite of the financial crisis) which saw emerging stocks outperform U.S. stocks by nearly 165%. In this context, we see the last 2.5 years of U.S. stock outperformance as a counter-trend correction.

Turning to sentiment, investor attitudes towards U.S. stocks and emerging market stocks have reached polar extremes. The next chart plots our Composite U.S. Market Sentiment Indicator (top) against a proxy sentiment measure for the iShares Emerging Market ETF, ticker EEM (bottom), composed of the put/call volume ratio and the 30-day volatility on the tracker. We see in the chart that investor optimism towards U.S. equities had been trending up since the end of 2011, reaching an extreme level in January (notably a level not seen since prior to the Sovereign Debt Crisis and U.S. debt downgrade). The extreme optimism towards U.S. stocks appears to finally be rolling over. Meanwhile, investor apathy towards emerging market stocks, has dragged sentiment to a pessimistic extreme, thereby potentially offering an attractive entry point.

Evidence of exhaustion in the relative price uptrend of U.S. equities, the optimism in the U.S market, and the pessimism in the emerging space are all beginning to appear. In addition, our Sector Rotation Model has flashed underweight alerts on major U.S. equity indexes for the first time since 2012. At the same time, a majority of emerging market indexes have, at long last, moved into the overweight mode. Several lines from the model are reproduced below (see the full version at www.WilliamsMarketAnalytics.com). Price behavior over the three weeks from March 21 to April 11, which saw the Nasdaq decline by -6.6% while the MSCI Emerging Markets index rose +7.3%, confirms the potential for EM stocks to rally this year even in the face of a U.S. correction.

To summarize, U.S. market internals are turning down just as we arrive at a seasonally unfavorable period for equities. While stocks may still be the most attractive asset class in a period of exceptional central bank intervention in financial markets, we recommend raising cash and rotating out of U.S. equities and into EM stocks during the higher market volatility in the coming weeks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.