Although the market ended the week on a high note, by trading up through the 1,335 level on the S&P 500 (SPY), macro news continues to be the catalyst for moves in both directions. In general, investors should be cautious when the market jumps around based on the latest piece of news from Europe. However, we have noticed some diverging dynamics in the "Risk Off" indicators that we review on a weekly basis.
In general, we are becoming wary of the obvious trade, which has been to sell risky assets because of the European crisis. The European crisis is not new, which means that more and more of it is being priced in. The upcoming market action will likely continue to be dominated by macro factors, especially the Fed meeting on June 19-20. Still, we are trying to decipher what is already priced into the market so that we avoid making the obvious trades.
We begin this market update by reviewing the price movements in the major U.S. indices and the market's reaction to recent news. Then we will look at the recent price movements in the "Risk On / Risk Off" indicators. Finally, we will present our bull and bear cases for the short term trading environment, as well as our updated investment plan.
The S&P 500 and Other Major Indices
Going into last week, we were watching the 1,335 level on the S&P 500 after it bounced off of the 200 day moving average. The 1,335 level was important because an upside breakout would indicate that the market gained new ground after a few weeks of mostly range-bound price movements. While the breakout through 1,335 is noteworthy, we want to see confirmation of this move early next week, and through the Fed meeting, before significantly increasing our long exposure.
The first chart of the S&P 500 below shows the daily price movements over a twelve month time frame and the second chart focuses on the hourly price movements over the last month, which brings into focus the recent range.
(click to enlarge all images)
(Source for charts, unless otherwise noted: FreeStockCharts.com)
The moves in the Dow Jones Industrials (DIA), Nasdaq (QQQ) and Russell 2000 (IWM) were similar to the moves in the S&P 500, but there are a few slight differences. Similar to the S&P 500, the Dow also seems to be making a new upside move and is nicely above its 20 day moving average.
However, the Nasdaq and the Russell 2000 have not yet broken out of their ranges over the last month and are still trading around their 20 and 200 day moving averages.
It is interesting to note the differences between the S&P 500 and the Russell 2000 so far this year. The following chart shows the year-to-date moves for the SPY and IWM, the ETFs that track each index (the IWM is marked in white)
The IWM, tracking the Russell 2000, had a much stronger start to the year. As the market emerged from the major correction last August and several months of range-bound price movements, the smaller, high beta companies of the Russell 2000 led the way up. After the Russell 2000 led the initial rally it was also the first index to enter a sideways range. When the market subsequently declined, the Russell 2000 then traded down to its 200 day moving average before the S&P 500. With the Russell 2000 moving a couple of steps ahead of the S&P 500 in both directions, it is interesting that it is now lagging the S&P 500 on the upside.
Last week, three macro news stories had significant influence over the market's direction. The first story was the bailout of the Spanish banks. The S&P 500 traded up on the rumor of the bailout and then "sold the news" and declined on Monday. As the week went on, yields on Spanish and Italian sovereign debt continued to rise indicating concern about the European crisis. However, it seemed that investor attention moved on to other issues.
On Thursday afternoon, rumors of central bank intervention drove up the market late in the day. Reports emerged that global central banks were prepared to act if the crisis in Europe gets worse. Similarly, the UK central bank unveiled a program to inject liquidity into its banking system.
The market's rejection of the Spanish bailout and the positive reaction to rumors of central bank action indicate the importance of monetary policy, the Fed and global central banks. Investors seemed to lose faith in the ability of European politicians to find solutions to the crisis. Instead, they are relying on the central banks. This puts added pressure on the U.S. Federal Reserve, which is set to meet on Tuesday and Wednesday (June 19-20), especially as the Fed's most recent program, Operation Twist, is set to expire at the end of the month.
Finally, rumors about the Greek election, to be held on Sunday (June 17), seemed to move the market on Friday. Investors seemed to be willing to buy equities and hold them through the weekend's election based on the assumption that the pro-Euro / pro-austerity parties would win, or, at least, the negative outcomes of the election were already priced in.
It will be interesting to see how the market moves on Monday in reaction to the election. However, the market's move after the Fed meeting on Wednesday is much more important.
Review of Key "Risk On / Risk Off" Indicators
As the European crisis continues to move the equity market, we are to closely watching the yields of European sovereign debt. The recent trend was for German bond yields to decline while Spanish and Italian bond yields rise. This dynamic indicated a flight to safety as investors preferred the perceived safety of Germany. However, last week, in the aftermath of the Spanish bailout, German bond yields rose together with the yields of Spain and Italy.
The yield on the German 10 year bond ended the week at 1.437%, up from 1.329% the prior week. Likewise, the Spanish yield rose to 6.874%, up from 6.216% the prior week and the Italian yield rose to 5.926% up from 5.772% the prior week. All three yields closed the week off the mid-week highs.
With the Spanish bond yield near the critical 7% level, debt investors are demanding a more promising solution from European politicians. If no solution emerges, then the European crisis may reach a more critical level.
The U.S. 10 year bond came off of its recent high prices and low yields last week. Nonetheless, it remains near record levels, as seen in the iShares Barclays 20+ Year Treasury Bond ETF (TLT), which tracks bond prices.
Despite the move away from risky European sovereign bonds, the U.S. high yield market continued to recover from its recent drop. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG) was up for the week.
Encouragingly, the U.S. financial sector rose as the Financial Select Sector SPDR ETF (XLF) continued the bounce off its 200 day moving average. There was some relief in the banking sector following the testimony before Congress by Jamie Dimon, CEO of JPMorgan (JPM), about JPMorgan's recent $2+ billion trading loss. In fact, JPMorgan and Citigroup (C)-- two large banks that have experienced significant declines recently-- were up for the week and may be turning around after trading near their 2011 lows.
However, the important move in the financial sector will be the one following the Fed meeting on Wednesday due to the sector's sensitivity to the Fed's liquidity programs.
Commodity prices were slightly up last week, as seen in the Thomson Reuters/Jefferies In-The-Ground CRB Global Commodity Equity Index (CRBQ). After several weeks of sharp declines, oil was flat and may be bottoming in the mid-$80 range. If oil ends its decline, the energy sector may become more attractive.
Despite the recent volatility, the CBOE Volatility Index ("VIX"), closed the week near where it opened, around 21. The VIX still has not spiked up to the highs of last summer, which may indicate that the correction may be coming to an end.
With the upcoming Greek election, followed by the Fed meeting on June 19-20 and the EU Summit on June 28-29, the macro story will likely continue to be the main driver of price action in the short term.
The Bull Case
The market ended the week on a positive note, breaking through 1,335 on the S&P 500. Although there is a lot of bad news, we have not yet had a major surprise that has rattled the market. Last week the market was rather resilient following an underwhelming Spanish bailout, which may indicate that the bad news is priced in at these levels. Furthermore, even if European politicians can't act responsibly, the market can seemingly rely on central banks to save the day.
On Wednesday, the Fed may propose another round of quantitative easing or, at least, an extension of Operation Twist. The details of the Fed's action may not be as important as the action itself, which would signal to the market that the Fed is putting a floor under the recent declines. The market does not necessarily need the situation to improve, but a temporary cessation of bad news could spark an intermediate term rally.
With expectations reduced, some good news (from the Greek elections, the Fed, corporate earnings, job numbers, etc.) could go a long way. Also, relatively low valuations for many companies could be a catalyst for buyers sooner rather than later. The obvious trade may be to sell because Europe is still a mess, but because that trade is obvious, it could be time to start looking in the opposite direction.
The Bear Case
The recent upside momentum may be temporary. With Spanish bond yields still near 7%, there is imminent risk to Spain's ability to fund itself, which may be spread to other eurozone countries. There was a sense that investors were operating according to the "buy on the rumor" thesis toward the end of the week, which could be followed by "sell on the news." The outcome of the Greek election may be a negative for the market, or it may already be priced it.
The Fed is the key variable in the short term. Although there is an expectation, or hope, that the Fed will act to support the economy it isn't clear that the Fed is inclined to do so. If the Fed does not meet investor expectations, the market could subsequently fall.
Finally, after investors digest the upcoming Fed move they may turn their attention to the outstanding Fiscal Cliff, which is another potential catalyst for declines.
Last week we initiated a few small long positions and also increased our shorts, but we continue to have an unusually large cash position. We have been waiting for some of the macro drivers to play out and now we are waiting for the Fed meeting before taking on large positions. We recognize that we may miss a large bounce following the Fed's announcement on Wednesday, but if a real rally emerges we will have enough time to capture most of the move. We would rather place our large bets when we have more conviction on the market and more clarity about the macro situation.
Disclosure: We have a position in the ProShares Short S&P 500 ETF (SH) and the ProShares Short Dow30 ETF (DOG). We may trade these positions or the stocks/ETFs mentioned in the article in the next 72 hours.