The S&P 500 (SPY) entered the week following a 6-day losing streak, three straight down weeks and the Facebook (FB) IPO let down. However, it managed to rebound in a week dominated by macroeconomic news and fears. The fact that the market could stop its decline in such a negative environment seems like a positive sign going forward; however, it will be difficult to sustain a rally if macroeconomic news continues to dictate trading action.
As we noted in our update last week (Market Update: S&P 500 Trading Range Breakdown And Key 'Risk Off' Indicators), the S&P 500 broke down from its trading range between 1,350 and 1,425, corresponding to 135.00 and 142.50 on the SPDR S&P 500 ETF. With the downward momentum building throughout May, it seemed like the SPY was heading toward its 200-day moving average at approximately 128, which was also near the bottom of the trading range from the first part of last year. However, the market rebounded and closed the week at 132.10.
(Source for charts, unless otherwise noted: FreeStockCharts.com)
We will review some of the key macro stories from last week, look at the "Risk On / Risk Off" indicators we discussed last week and update our investment outlook as we prepare for the trading week ahead.
Macro Stories From Last Week
The market got off to a good start on Monday as comments by Chinese officials led to speculation that the government would initiate further economic stimulus (Wen Growth Pledge Spurs Speculation of China Stimulus).
The market then shifted its focus to the Greek situation. European leaders met for another summit, which generated a lot of rumors and speculation about a possible Greek exit from the euro. The consensus seems to be that the likelihood of a Greek exit has increased; however, we have not passed the point of no return. Since the consequences of an exit could be disastrous, European nations may still act to prevent it from happening. The Wall Street Journal presents an overview of the views of several economists on the Greek exit: Greek Euro Exit By Numbers: What Economists Expect.
Spanish banks continued to come under pressure this week. Spain's Bankia announced that it was seeking a E19 billion bailout from the government (Bankia Seeks 19 Billion Euros From Spain For Cleanup). Furthermore, the slow motion run on Spanish banks seems to be an ongoing risk (In Spain, Bank Transfers Reflect Broader Fears).
The week ended with a some negative news about the Chinese banking system and economy. Chinese banks may miss their lending targets this year, following a drop in lending in April and May (China Banks May Miss Loan Target For 2012, Officials Say). The decline in loan demand may indicate that China is not meeting its growth targets. In response, Chinese officials seem to favor economic stimulus to accelerate economic growth this year, but it remains to be seen if the Chinese government can continue to engineer enough growth. A decline in China's pace of growth could have repercussions across the globe. Furthermore, commodity prices, which have been rising over the past few years on increasing demand from China, may be at risk with slower Chinese growth.
Review of Key Risk On / Risk Off Indicators
When macro risks dominate the market, the financial sector is especially vulnerable, so we are monitoring it closely.
JPMorgan (JPM) experienced significant declines following the announcement of its $2 billion trading loss, but managed to trade flat for the week and close at $33.50 per share. JPMorgan lost approximately 20% of its market value in May and we are encouraged that it managed to halt its declines this week. Nonetheless, the stock may re-test the lows from last year in the $28 per share range, if macro risks persist over the summer.
Similarly, the Financial Select Sector SPDR ETF (XLF) posted a slight gain this week after bouncing off of its 200 day moving average, a key level for the overall market. This week's trading action in the financial sector seemed positive and we will continue to follow this XLF to see if it sustains its bounce off of the 200 day moving average.
In response to the negative news about the situation in Greece and the Spanish banks, the Spanish 10 year bond yield continued its rise this week. Spain's 10 year yield closed the week at 6.31%, up from 6.27% the week before.
Italy's 10 year bond yield declined to close at 5.66%, down from 5.81% the previous week. The decline in Italy's yield is encouraging, but it remains elevated and has a long way to go before exiting the zone of worry. By contrast, Germany's 10 year bond yield was 1.37% at the end of the week.
Another sign of European weakness is the euro/US dollar exchange rate. The euro has been in decline since May 2011 and reached the 1.25 level this week. The Wall Street Journal article discussed above includes predictions for the euro in the event of a Greek exit. Most economists believe that if Greece leaves the euro, the euro would drop further. Therefore, investors may be selling the euro in advance of such a move.
Oil declined this week as well. The price for WTI oil closed at $90.66 per barrel after breaking below the $90 level earlier in the week. Lower oil prices will continue to drag down energy stocks, which are already suffering from low natural gas prices. Although the Energy Select Sector SPDR ETF (XLE) was up slightly last week, it is still down on a year-to-date basis.
The decline in oil prices may result from a slowdown in economic activity, which is reducing demand. However, the fact that oil prices have declined a significant amount over the last few weeks should help companies that use oil as a raw material.
As we discussed above, China's growth rate may be less than expected this year. Already, the Shanghai Stock Exchange Composite Index has been a relative underperformer. The first chart below shows the Shanghai SE Composite Index over the last 2 years and the second compares it to the SPY, marked in yellow. We are not experts in China, but the relative underperformance of Chinese shares does not bode well for the market.
The Risk Off trade of the last few weeks seems most evident in the bond market. The iShares Barclays 20+ Year Treasury Bond ETF (TLT) is a proxy for long dated US treasury bonds. As seen in the chart below, the TLT has been rallying which indicates increasing demand for safe haven US treasuries. By contrast, the iShares iBoxx $ High Yield Corporate Bond (HYG), a proxy for high yield bonds, has traded down from its recent highs and is at a year-to-date low. Demand for bonds has not extended to the high yield market, which is the riskier part of the bond spectrum.
The CBOE Volatility Index (VIX) is another way to look at Risk Off sentiment. Although the VIX declined last week, it still is elevated and closed the week at 21.76. Generally, there is some concern if the VIX is over 20, but the current level is far from the mid-40 range that indicates panic during major declines.
We continue to follow Apple (AAPL) as an indicator for US stocks. Apple was a leader during the Q4/Q1 rally and is now the largest single component in the S&P 500 / SPY. Apple rebounded this week from an intra-day low of $522 per share last Friday, slightly below its 100 day moving average, to close the week at $562 per share.
However, Apple is still approximately 13% below the year-to-date high that it reached in early April. Furthermore, Apple's stock has been struggling in the aftermath of its Q1 earnings announcement, which contrasts with the rally that it sustained following its Q4 earnings release. Considering Apple's weighting in the S&P 500 / SPY as well as its psychological impact on the market, we think that it will be difficult for the market to launch another multi-month rally without leadership from Apple. Apple's recent performance seems to indicate that it will take some time before it can launch another major upside move.
Finally, on a more positive note, the SPDR S&P Homebuilders ETF (XHB) has held up rather well compared to the rest of the market.
The Bull Case
Despite all the bad news last week, the market halted its downtrend. Maybe the bad news about the Greek exit, Spanish bank runs, slowdown in China and underwhelming US growth are priced into stocks. Furthermore, there was no major sell off on Friday in advance of the long Memorial Day weekend, which could indicate that investors are more willing to hold risky positions.
A few weeks ago everybody was taking about the "sell in May and go away" thesis, but after a miserable May maybe all the sellers have already made their moves. The financials, for instance, have declined, but are staying above a key level.
The negative headlines may push the Federal Reserve to launch another round of quantitative easing when Operation Twist expires in late June, which could be a catalyst for a rally in the market. Similarly, a Chinese stimulus could trigger global growth.
The Bear Case
Bears will brush off the trading action last week and attribute it to a short term bounce off of oversold conditions. The market took a break from falling, but more declines may lay ahead.
A market that is pushed around by macro rumors and speculation does not seem positioned for a rally. The European situation seems more likely to get worse before it gets better and the fear of the unknown in Europe (Greek exit, Spanish bank runs, etc.) could be a catalyst to sell and reduce equity exposure this summer. Furthermore, we face additional risks later in the year due to the US election as well as the Fiscal Cliff.
Last week we noted that our short term outlook dictated caution. We had been reducing our market exposure and building up our cash position. We remained rather defensive last week as we adopted as wait and see approach to the market, but we were encouraged by the bounce that we saw last week. We are still cautious, but if we see upside follow through at the beginning of next week we will likely increase our long exposure and initiate some new positions.
Additional disclosure: We have a position in JPM and the ProShares Short S&P 500 ETF (SH). We may trade these positions or the stocks/ETFs mentioned in the article in the next 72 hours.