The S&P 500 (SPY) ended a very eventful week not far from where it traded on Monday. The market digested the Greek election, the Federal Reserve's decision to extend Operation Twist and the highly anticipated downgrades of 15 global banks. From a technical perspective, the S&P 500 broke out of a month-long trading range, but retreated back inside while flirting with various moving averages. The market's roller-coaster to nowhere is an indication of confusion and, maybe, some sense of equilibrium between the bulls and the bears with no side gaining much of an advantage. In previous updates we discussed the need to avoid the obvious trade. We want to take that line of thinking one step further and change the way that we are looking at the market and our investment plans.
In our update below, we will discuss the major events of last week and then look at how the S&P 500, Dow Jones, Nasdaq Composite and Russell 2000 reacted to the news. We will also comment on the components of the "Risk On / Risk Off" trade. Finally, we will discuss the bullish and bearish cases and our updated short term investment outlook.
Recent Macro Stories and "Buy the Rumor, Sell the News"
There has been a potentially market moving macro event during each of the last few weeks. First we had the Spanish bailout (June 9-10), then the Greek election (June 17) and Fed meeting (June 19-20). Investors had high expectations for each of these events and their optimism lifted the equity markets. However, the actual events either fell short of expectations, or barely met expectations, and the lack of positive surprises prevented the market from rising further.
The market bounced off of its low on June 4 in advance of the Spanish bailout on June 9-10. Following the announcement of the bailout criticism emerged that it was not sufficient because of the lack of clarity of the funding mechanisms and other factors. The S&P 500 reacted to the news with declines when trading began after the announcement.
After that Monday drop, the market rose into the Greek elections the following weekend. Although the pro-Euro parties won enough power to establish a coalition, the market opened down the following the news and closed the day basically flat. This time, the news was as good as it could get, but we believe that investors realized that one election would not solve the problems of Greece or the Euro, so it was not enough of a reason to cheer.
After the lackluster response to the Greek election, the market rose in advance of the Fed meeting on Tuesday and Wednesday in anticipation of the extension of Operation Twist and potentially more aggressive action from the Fed. The S&P 500 had a volatile initial reaction to the news and then traded down on Wednesday afternoon and Thursday. The Fed's extension of Operation Twist was in-line with market expectations, but there was no upside surprise to push the market higher. Also, the Fed's outlook about future growth was disappointing.
The underlying theme of these events is that widely anticipated baby steps are not going to launch a sustained rally. The problems in the U.S. and Europe are complex and the political leadership is underwhelming. In this environment, baby steps are constructive, but leave the bears with enough pessimism to push the market down in the short term. The result is confusion instead of a clear trend. We will become more positive on the market when it rallies through a macro event, instead of repeating the "buy the rumor, sell the news" trade.
There was a lot of talk on Thursday and Friday about Moody's downgrades of 15 banks. However, we think that this story had a minimal impact on the market as the banks traded up on the news of the downgrade, which indicates that the news was already priced in long ago.
The S&P 500 and Other Major Indices
In our update last weekend we discussed the importance of the 1,335 level on the S&P 500. The 1,335 level was the high end of a month-long trading range (or inverse head-and-shoulders pattern, as some have been discussing). The S&P 500 seemed to launch an upside breakout from this level early in the week, but retreated on Thursday and closed the week precisely at 1,335.
Since the market ended its Q4/Q1 rally in early April, the S&P 500 has traded in two ranges. The higher range was from approximately 1,360 to 1,420. After breaking down from this range, the S&P 500 traded mostly in the 1,295 to 1,335 range. Last week, the S&P 500 tried to rise to the upper range, but closed the week back in the bottom range.
In previous updates, we also discussed the moving averages and especially the test of the 200 day moving average in early June. However, at this point it seems that the moving averages have less meaning. Moving averages are helpful tools in trending markets, but are less helpful in range-bound or sideways markets. Therefore, we are more focused on how the S&P 500 trades around the ranges discussed above than the price movements around the moving averages. If and when a trend emerges, either up or down, the moving averages will likely have more meaning.
(Source for charts, unless otherwise noted: FreeStockCharts.com)
The Dow Jones Industrials Average (DIA), Nasdaq (QQQ) and Russell 2000 (IWM) moved in a similar fashion to the S&P 500. The following charts show the year-to-date price movements, to more clearly focus on the recent action.
It is interesting to note that the Dow Jones Industrials Average is doing the best out of the four major indices by staying above its prior month's trading range. By contrast, the Russell 2000, which consists of smaller companies, is having the most trouble breaking out of its recent range. The fact that large cap stocks seem to outperform small cap stocks recently does not seem like a good start for a rally.
We are entering the last week of the second quarter, which will be followed by earnings season in early July. It will be interesting to see how the equity markets react to Q2 earnings season, following the disappointing reaction to Q1 earnings. Now that the Fed has reduced its growth expectations for the U.S. economy, many analysts will likely reduce their projections and some companies will likely reduce their guidance. The question for the market is whether the recent declines have already priced in these lower expectations or will the Q2 numbers lead to new lows.
Risk On / Risk Off Indicators
We have been closely following several different markets over the past few weeks as there seemed to be a broad move to relatively safe assets from risky assets. However, some of these correlations are diverging. It seems that the "Risk Off" trade, characterized by tight correlations between certain asset classes, has run its course, but it has not been replaced by a "Risk On" rally.
For instance, Spanish and Italian bond yields have been coming down, indicating investor concerns about these countries are retreating. But, that hasn't translated into a rally in the S&P 500 and equity markets. In fact, the decline in oil seems to indicate that there are lingering concerns about a deceleration of global growth.
The price movements in the European debt markets were clearly the best piece of news for equity market bulls. The yield on the Spanish ten year bond yield ended the week at 6.38%, down from 6.87% the prior week. Similarly, the Italian 10 year bond yield ended the week at 5.80%, down from 5.93% the prior week. While these declines were significant, the Spanish and Italian yields are still in uptrends and it will be interesting to see if they can break the upward momentum this week.
The yield on the German 10 year bond rose last week to 1.58% from 1.44% the prior week.
The following are the charts for the 10 year bonds for Spain, Italy and Germany.
Debt investors may have been bidding up the prices of Spanish and Italian debt in advance of the EU Summit on June 28 and 29. There is growing optimism that this summit (and the pre-summit talks over the weekend in Rome) will produce a more market friendly solution to the ongoing crisis. It will be interesting to see if European politicians can finally deliver a comprehensive solution or just more baby steps.
The Euro continued to rebound off of its recent low. However, it is still trading in the 1.25 range.
The U.S. 10 year bond yield closed the week at 1.67%. Bond prices remain near record high prices, and yields near record lows, at seen in the iShares Barclays 20+ Year Treasury Bond ETF (TLT), which tracks bond prices.
The continued rebound by the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) indicates strength in the riskier parts of the U.S. bond market and is a good sign for equities.
U.S. financial stocks are continuing to rebound off of their early June lows. Despite Moody's downgrades of 15 banks, the Financial Select Sector SPDR ETF (XLF) was up on the week.
Furthermore, Citigroup (C) and JPMorgan (JPM) are both continuing to rebound off of their recent large declines. As we have mentioned previously, we think that the market will need leadership from the financial sector, including banks like Citigroup and JPMorgan, if it launches a new rally.
While the financial sector has been strengthening, the utilities sector was weak. Over the last year the utilities sector has help up well, especially compared to more cyclical industries. However, the decline of the last few days may indicate a rotation out of defensive stocks and into more risky parts of the market. The following chart shows the resent price movements in the Utilities Select Sector SPDR ETF (XLU).
In contrast with the encouraging signs from the bond markets and the financial sector, the oil market is telling a different story. WTI Cushing Crude Oil closed the week at $79.36 per barrel. Similarly, Brent Crude Oil declined to $90.98 per barrel. The sharp declines in oil may be indicating a softer global economic environment and therefore less demand. With WTI Crude Oil below $80 and close to the October lows it will be interesting to see if the price stays at this depressed level or rebounds.
The multi-month decline in oil will likely bring down earnings for the energy sector in Q2. It will be interesting to hear how CEOs of energy companies talk about their guidance for the coming quarters.
Other global commodities are also down, as seen in the Thomson Reuters/Jefferies In-The-Ground CRB Global Commodity Equity Index (CRBQ).
Another encouraging sign for the bulls is the decline in the VIX - CBOE Volatility Index (VXX). The VIX closed the week at 18.11, below the significant 20 level. The correction of the last few weeks was accompanied by much lower volatility, as measured by the VIX, compared to the correction of last summer. This was one indication that the current correction may not be as extreme.
Apple (AAPL) is a good example of a stock that is caught up in the current confusion that is gripping the market. For the last 10 weeks, Apple has alternated between up and down weeks. The weekly chart of Apple below nicely portrays this confusion with alternating green and red candles. Since Apple ended its impressive Q4/Q1 rally it has not moved much and is trading near the level it was at before Q1 earnings. Like the financial sector, we think that the market will need a breakout from Apple to launch another sustained rally, though it does not seem like Apple is currently positioned for another major upside move.
A couple of weeks ago we mentioned that Wal-Mart (WMT) was trading near its record high level. Although Wal-Mart has not yet broken above its all time high of $70.25, it seems to be holding onto most of the recent gains.
The Bull Case
There are some encouraging signs on the macro level. The Spanish bailout, Greek elections and extension of Operation Twist should help the equity market. Even if these actions did not overwhelm investors, they demonstrate that decisions are being made on multiple fronts to avoid disaster. Although the market recently experienced a 10% correction, there has not been a crisis to act as the catalyst for a panic-driven follow-on move lower.
The next few weeks may continue to be difficult, especially as investors lower their expectations further following the Fed's downward revision of U.S. growth. However, the market has been resetting its expectations for a few months and should hopefully reach the low point of expectations soon. With low expectations and seemingly low valuations for many companies, the market may be closer to another rally than another correction.
From a technical perspective, if the S&P 500 can stay above 1,335 and get some help from the XLF and the financial sector, it may be able to move back up into the upper range from the last few months and re-test its year-to-date highs.
The Bear Case
Although we have not had a major macro crisis event, macro events continue to dominate the market. In this environment, especially with the underwhelming response from the various decision makers, it is difficult to bet on another market rally. It is easy to imagine a drawn out period of macro doldrums with the upcoming U.S. election and pending Fiscal Cliff.
Furthermore, recent reports indicate a slowing pace of growth in emerging markets, especially China.
We expect a lot of downward revisions to earnings projections in the next few weeks before earnings season begins and reduced guidance from companies when they announce their numbers. Although the recent declines have priced in some of the reduced earnings, there could be further earnings related declines.
From a technical perspective, the S&P 500 could not sustain a breakout from its recent range and ended the week back in the range. If the S&P 500 stays in this range, the next move may be to test the bottom of it.
Over the last few weeks we have maintained a cautious approach to the market by maintaining large cash positions. Although we have initiated some new positions, they have mostly been small. The new positions have consisted of both longs and shorts, but there have been more new longs.
Last week we mentioned the need to avoid the obvious trade. Although the events in Europe are problematic, they are not causing further panic and sharp declines. It seems that either the market believes that the European situation will sort itself out or current asset prices reflect the short and mid term risks. Therefore, betting on a large market decline in the near term based on European events does not seem like a good risk/reward proposition.
However, it is not so clear that we will get a significant rally from here. Following the impressive Q4/Q1 rally that reached its peak in April, the S&P 500, and the equity markets more broadly, will likely need more time to consolidate those gains before launching the next big move. The Q4 2010 / Q1 2011 rally through February 2011 was followed by five months of sideways action before its next big move, which was lower following the U.S. credit downgrade in August 2011.
The difference between the sideways trading action this summer and last summer is that this summer we seem to have had an higher range (1,360 to 1,420 on the S&P 500) and a lower range (1,295 to 1,335 on the S&P 500). However, if the bulls and bears are reaching a temporary equilibrium, which could be exacerbated by the summer trading environment, the S&P 500 may continue to trade between its year-to-date high of approximately 1,420 and its recent low of approximately 1,265 in the beginning of June.
Currently, our short and mid term investment outlook is that this range will perpetuate for a few months. We will seek to add to our positions at the low end of the range (in the low 1,300s on the S&P 500) and sell toward the top end (around 1,400 on the S&P 500). It sounds like an easy strategy, but is hard in practice as the low end of the range will likely be accompanied by bad news, thereby making the longs counter-intuitive, and the top end will likely be accompanied by optimism for an upside breakout.
Another consequence of a multi-month trading range could be the breakdown of correlations, in which case it will be easier and more rewarding to pick individual stocks that can breakaway from the general market action. Although we discuss macro issues in our weekly updates, we are primarily a bottoms-up, fundamental investors that are seeking attractive risk/reward opportunities in individual equities.
As always "how you invest" is just as important as "what you invest in," meaning that risk management is as important as ever.
Additional disclosure: We have positions in C, JPM and the ProShares Short QQQ ETF (PSQ). We may trade these positions or the stocks/ETFs mentioned in the article in the next 72 hours.