The most widely followed benchmark index for U.S. equities, the S&P 500, set an all-time closing high on May 21, 2015 at 2130.82. For over one-year, the benchmark index has not managed to climb above this high. As the S&P 500 flirts once again with the 2130.82 record high, we thought it would be useful to compare the situation "then and now" to better assess the probability of the index continuing higher to set a new series of record highs. We will focus on our favourite market indicators in this Commentary and will compare the macroeconomic conditions and micro valuations in a latter missive. However, in a nutshell, we see macro indicators generally weaker today versus one-year ago, as U.S. real GDP has slowed over the past four quarters. Equity valuations are also less attractive today than in May 2015. The U.S. is in an earnings recession, yet aggregate equity prices are about the same as one-year ago. For the moment, equity valuations don't seem to matter; however one day they will matter again. The market indicators we consider below are, in aggregate, positioned similarly to levels seen in May 2015. We first present our market indicators, then offer our conclusion regarding the likelihood of U.S. equities moving significantly above the May 2015 highs.
The cumulative advance/decline line (A/D line) gives a running total of the number of issues in an index (or on an exchange) that advance for the day less those that decline for the day. This indicator is used to confirm the strength of a current trend and its likelihood of reversing. A rising equity price index accompanied by a stable or falling A/D is generally unhealthy. And this is what we witnessed in 2015 (see chart below). The A/D line for the S&P 500 (NYSEARCA:SPY) began stalling out in February 2015, several weeks ahead of the price peak on the S&P 500 in late May. Fast forward to today, and we observe a strong upward trending A/D line confirming the higher prices on the S&P 500. The large cap equity market is showing much better breadth in 2016; that is, more issues are participating in the rising S&P 500 price. Bulls can perhaps point to the breadth of the market advance to justify higher prices.
However, the A/D line has been more a coincident indicator, moving in lock-step, or "confirming" equity indexes. We have always liked to look at momentum of the A/D line. Using a trader's month (21-days) rate of change, we see in the chart below that the A/D momentum has been trending down since April. We saw the same underlying weakness in the A/D line starting back in late October 2015….not the best omen for today. Back in May 2015, the A/D line and momentum were flat, so no direct comparison can be drawn with the A/D line today.
Percent of Stocks Above 200-Day Moving Average
Another indicator we use to measure the breadth of an equity advance is the percent of stocks in the index above their 200-day moving average. The more component issues in an uptrend, the stronger the market, in theory. In practice, we use the Percent above Moving Average as an over-bought/over-sold indicator as well as a trend indicator. Today the Percent above Moving Average is about the same as in May 2015. As an over-bought/over-sold indicator, the Percent above Moving Average is therefore mildly bullish and equities are not extremely over-bought. But historically, the market has put in major tops with the Percent above Moving Average in the 70% - 80% range. With over three quarters of S&P 500 stocks already above their 200-day moving averages, expecting a prolonged move to the upside does not make sense. One difference with May 2015 is that the Percent above Moving Average was trending down at the time whilst the indicator is trending up today. In this sense, the indicator may be slight more constructive than in May 2015.
Short interest data was updated Thursday night. We have already presented the Short Interest Ratio (NYSE:SIR) in our Thursday update. We reprint the chart below with the May 31 reading. Recall that the short-interest ratio is the number of days (based on the average trading volume of the stock) that it would take all short sellers to cover their short positions. For example if the average daily volume on the NYSE for the week is 750 million shares and short interest on the exchange is 1.6 billion shares, the SIR would be 2.13 days. When the SIR is trending higher, investor sentiment in the index is deteriorating. Moreover, a high SIR means a greater potential for a short-covering rally. However, as our chart below shows, the SIR has not behaved as a typical contrarian sentiment indicator. High SIR readings (large short interest positions, bearish sentiment) have in fact been excellent selling opportunities. Conversely, low SIR readings (relatively small short interest positions, bullish sentiment) have recently proved to be great buying opportunities. Our reasoning is that sophisticated investors (the "smart money") are primarily the investors engaged in shorting, not the average, uniformed investor (who is usually wrong at market extremes).
Let's first look at the recent low SIR readings. We have circled in green the four occurrences since 2012 when the SIR fell to 3.5 days. Here are the corresponding levels on the S&P 500 and subsequent performance (from left to right in the chart):
February 2013: S&P 500 cyclical low at 1485. The index rallied +12.5% over the subsequent 3 months. June 2013: S&P 500 cyclical low at 1560. The index rallied +11% over the subsequent 3 months. January 2014: S&P 500 cyclical low at 1740. The index rallied +15% over the subsequent 8 months. January 2016: S&P 500 cyclical low at 1812. The index rallied +15% over the subsequent 4 months.
Now for the SIR high readings, circled in red. We note the three occurrences when the SIR exceeded 5.0 (again, from left to right).
Mid-July 2014: S&P 500 cyclical high at 1987. The index fell -3.5% over the subsequent month. August 2014: S&P 500 cyclical high at 2000. The index fell -8% over the subsequent 2 months. June 2015: S&P 500 cyclical high at 2120. The index fell -11.6% over the subsequent 3 months.
Another short interest chart we like is our in-house Total U.S. Market Short Interest relative to U.S. Total Market Capitalization. The Total Market Cap number, compiled by Bloomberg, only includes actively traded primary securities on U.S. exchanges, excluding ETFs and ADRs. This data reasonably reflects the size of U.S. equity markets. The ratio of short interest to market cap traces an informative curve. We note two points. First, we like to watch the trend of this ratio. A falling trend is bullish, a rising trend is bearish. Since March 2009, the overall trend has been down: a major bull market. However since May of 2015, we perceive a reversal of the trend, as shown by our dotted trend lines. Short activity is coming back into vogue.
Second, we see that selling after the ratio has spiked up has been a bad trade. The dates highlighted on the chart correspond to the "major" troughs in the recent bull market. The table below shows how much the Short Interest / Market Cap ratio has moved up before selling pressure became exhausted. The theory behind this read of Short Interest is simple: once all traders inclined to shorting have put on their shorts, there is no one left to short. And we know that all equity rallies begin with short covering.
Ratio Point Change
(final move up to peak)
Mean Point Change
The take-away here is that selling (or opening short positions) after the Short Interest / Market Cap ratio has moved up significantly has been a very poor timing decision. This was seen once again by traders who added to shorts (or investors who capitulated and sold) this February (red circle). The ratio has actually now moved down enough through the end of May (shorts have bailed out) to make selling/shorting once again a high probability trade.
Another piece of market data we have found useful is the amount of margin debt held by investors. The margin debt figure in our chart below is the total amount (aggregate) debit balances in customer securities margin accounts held at NYSE member firms. When investors get enthusiastic about rising stock prices, they borrow money ("leverage up") to puts more dollars into equities than the amount of dollars held in their brokerage accounts. In other words, rising margin balances measure to what degree the stock market becomes a casino. Are for those who have frequented Las Vegas or Monte Carlo, you will know that most gamblers return home with empty pockets.
We deflated margin debt levels using the CPI to accurately compare real margin debt levels across time. We then compare our real margin debt to real household income. The logic here is that if household income rises, households have the means to allocate more to speculative equity positions. If household incomes don't rise proportionately to the increase in margin debt, this is a sure sign that the rising margin debt is coming from mores speculative sources. The chart below shows the last three major peaks in real margin debt on the NYSE. It is not a coincidence that the last three U.S. equity bull market peaks occurred in March 2000, October 2007, and May 2015. The August 2007 real margin debt / real household income ratio peaked 14% above the March 2000 peak. The May 2015 peak was 23% above the August 2007 peak. Betting margin debt will climb even further above the previous peak is just not rational (we'd say insane). Note also, that to flush out all the margin debt accumulated over seven years, historically our ratio has fallen back, on average, 70% of the amount accumulated over the prior expansion (using data since 1970). That would suggest our ratio needs to fall to 1.2x. This would take a long, painful bear market to occur.
Equity Volatility Indexes
Complacency reigns…just as we saw at the May 2015 S&P 500 top. Looking at the VIX volatility index (measure of the implied volatility of S&P 500 index options), we have entered a period of low volatility, eerily similar, both in time and tightness of the volatility range, to that which preceded the market top in May of 2015. If market bottoms are made on spikes in the VIX, market tops are formed after prolonged periods of low volatility. Don't bet that the VIX will remain subdued for a longer period than we have seen in the recent past.
Foreign Stock Markets
U.S. equities have suffered a few sell-offs since the 2015 high, but managed to return to last year's highs. Elsewhere, however, almost all other world equity markets remain in bear markets.
The Nikkei 225 average in Japan peaked just after the S&P 500 in May of last year. The Japanese stock market reflects slowing world economic growth and remains about -20% below 2015 highs.
The Dow Jones Stoxx 600, our Pan-European benchmark, peaked a few weeks before the S&P 500 in May of last year. The European stock markets also reflect slowing world economic growth and remain collectively about -16% below 2015 highs.
The MSCI Emerging Market made a cyclical peak in 2014 (the post-crisis peak dates all the way back to 2011). The Emerging stock markets again reflect slowing world economic growth and remain in aggregate about -24% below 2014 highs.
Aside from some niche stock markets (such as New Zealand and South Africa) all major world indexes have recently entered a bear market (-20% off highs) and remain currently well below post crisis highs. While the reasons for the U.S. market's exceptional perform (to the present) can be summed up by the word "Fed", investors need to reflect on the"normalization" of world equity markets. Of course, in a given cycle one national equity market can largely outperform another nation's equity market. However, over time world equity performance tends to "even out". With integrated world financial markets, over time capital will flow towards economies and equity markets with the best growth prospects and most attractive relative valuations. There are really only two possibilities going forward: (1) the U.S. market will be the last shoe to drop among world equity indexes or (2) Fed policy has allowed equities to "take a pass" on this global wave of stock market corrections and U.S. equities will just pick up and rally in lock-step with the above indexes when their next bull market begins. We have a major problem with scenario two. Over time, equity valuations really are what matters, and if U.S. equities never suffer a bear market it will be hard to expect a positive correlation with other world equity indexes going forward. Already stretched U.S. equity valuations would become absurd and eventually even the not-so-savvy investors will wake-up and rotate into relatively cheaper foreign stocks.
Back in May 2015, U.S. government bonds had rallied to a cyclical high in January 2015 (the 10-year yield fell to 1.64%) and entered a corrective A-B-C three wave pattern. The Treasury corrective wave ended in June 2015 with the 10-year yield at 2.50%. Today, bond markets are moving in the other direction. The 10-year U.S. yield is now about 1.70% versus 2.30% at the beginning of 2016. On the chart below, each time this year interest rates try to back-up, Treasury buyers are stepping in at lower and lower yields. Treasurys are in a bull market. In the first half of 2015, rising equity prices and falling bond prices were compatible - the economy was believed to still be in expansion. Today, rising equity prices and rising bond prices are not compatible. That is, either the bond market is wrong or the equity market is wrong. The bond market says the economy is heading for recession, the equity market says the economy is gearing up for a longer expansion. In sum, higher equity prices in Q1 and Q2 of 2015 were confirmed by bond markets. Higher equity prices in June 2016 are not being confirmed by the bond markets. And when the bond and equity markets disagree, it's typically a better bet to go with the message of bond markets.
Federal Reserve Policy
As markets are being driven by monetary policy, we will, ironically, group Fed policy among our market indicators. Federal Reserve monetary policy has essentially remained unchanged since the May 2015 peak in U.S. equities. In May 2015, the Fed had finally ended additional quantitative easing (in October 2014), after much back-and-forth debate. Recall that it was Bernanke way back in 2013 who first evoked the end of QE (launching a "test balloon"). Markets got upset (the S&P 500 fell a whopping -5% back in 2013) and the Fed ended up pushing QE purchases another 16 months longer. We see a parallel with the announced rate tightening cycle. After much back-and-forth on the "lift-off" date, the Fed finally decided to increase rates by 25 points in December of 2015 (over two years since some Fed officials, notably Jeffrey Lacker, began calling for rate normalization). But markets got upset, and lo-and-behold, the Fed is now pushing back further rate hikes. The state of the markets is laughable. The U.S. economy is too weak for the Federal Reserve to continue normalizing raising rates within the next six months (at least according to the most recent forward guidance by Yellen), yet risk assets are rising primarily on the incapacity of the Fed to normalize rate!
As Fed policy is the same today as in May of 2015, we would not understand how "news" of more accommodation from the Fed would justify higher equity valuations. Of course markets are not rational and in the short-run investor miss-interpretation of Fed policy "changes" could drive prices higher. But not much higher. Fed policy gaming alone is not enough for a tradable leg higher in equities, in our opinion.
WMA U.S. Composite Market Risk Indicator
As of the morning of June 10, our U.S. Composite Risk Indicator was at 84.6, above the level on May 21, 2015 of 79.8. Prolonged periods of "Risk-On" trade tend to progressive exhaust themselves. The indicator recently made a late April high at 91.3. We are expecting to see deterioration in our risk indicator, with falling highs…much like we saw in Q1 and Q2 of 2015.
WMA U.S. Market Sentiment Indictaor
Sentiment is perhaps the best market indicator out there. It pays to go with the flow until market sentiment reaches an extreme, at which time savvy traders reverse their positions. Our Market Sentiment Indicator shows that the brief "touches" in the Extreme Pessimism zone were great buying opportunities recently in September 2015 and February 2016. Conversely, since the bull market high in May 2015, at which time our indicator topped out at 74.0, we have seen equities rallies end each time the indicator gets to the 70.0 - 74.0 range. The recent April high came in at 72.0. As nothing has really changed since May 2015 (same Fed policy, same sluggish economic growth, same over-valuation of equities), it would be unreasonable to expect our sentiment indicator to return to the Extreme Optimism zone in today's environment. We are betting that the April sentiment high will be the last high of this year.
Nothing today portends that the markets are on the verge of breaking to new record highs. Our market indicators suggest no more potential upside than we saw in May 2015. No one can reasonably argue that, after four quarters of slowing earnings with equity prices still near all-time highs, that stocks offer much (if any) potential for P/E expansion. The economy is slowing and it would be wishful thinking to proclaim that the shocking May jobs report was a one-off anomaly. Most concerning is the degree of complacency in today's U.S. equity markets, as evidenced by three months of low volatility, still very high real margin debt levels, and a recent plunge in our Short Interest / Market Cap ratio. Whether traders wish to see a print on the S&P 500 above 2130 is anyone's guess. But the evidence today suggests that any surge higher in U.S. equities is likely to bring prices back down even faster.
Disclosure: I/we 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.