Proceed With Caution Short-Term; Long-Term Uptrend Intact

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Includes: DIA, SPY
by: Phillip L. Clark

Domestic and foreign stocks came under heavy selling pressure last week for [only] the fourth time this year. The Japanese stock market fell some 7% and other foreign markets followed. The S&P 500 finished down 1.0% for the week and brought renewed skepticism to the unflappable bull. It took nothing more than misconstrued hints of stimulus spending reaching an end. Is that really what Fed Chairman Ben Bernanke meant to say? I don't think so and I certainly don't see any tapering at this point. Concluding that stimulus will remain in play for the foreseeable future, perhaps the "sell in May and go away" premise is nothing more than a myth. Especially since May has only been in our rear view mirror for a few days. Lest we forget, statistics show the worst months of summer lie ahead. On the other hand, it is defensible that "risk-on" will be the prevailing theme into and beyond summer. Before we delve into the "sell in May" axiom, let's look closer at the Fed's latest speak and what it might be telling the markets

The Fed's message, while controversial to many, didn't' seem much different from usual. Of course, everyone listening seems to hear something different from the previous message. But the fact remains, easy money has boosted asset prices and markets will be highly sensitive to any change in the Fed's QE and zero interest rate policy. That's not to say that stimulus money is the main driver of our economy. However, the hint of making money more difficult to obtain, before the economy can stand on its own, could be catastrophic. Assuming economic conditions continue to improve, contraction of stimulus could be appropriate by as early as year-end 2013. Nonetheless, Ben Bernanke isn't about to turn off the spigot until he is certain that recent improvements are sustainable through the summer and fall. He also knows that any fiscal tightening could be deleterious to global markets. It is my opinion that quantitative easing isn't going away anytime soon. In fact, the federal budget deficit has decreased and that could open the door to additional stimulus. Either way, more data will be required before Mr. Bernanke scales the easy money environment.

The majority will agree the last week's significant sell-off was sparked by comments from Ben Bernanke. But a few other factors should not be ignored. First, China's Purchasing Managers' Index slipped back into contraction for the month of May with a reading of 49.6, down from 50.4 in April - a seven month low. A slow down out of China is more than enough to renew global slowdown fears. For Japan's 10-year government bond touched 1% and Europe, mired in recession, continues its struggles to gain any real traction.

Getting back to the "sell in May" theory, we can't count the number of headlines that imply this notion to be farcical and not worth any attention. After all, stocks haven't tanked and May is all but gone and stocks are up more than 4% for the month. But May has never been the problem; the idea behind "Sell in May" is to get out of the market and protect those early year profits before the dubious summer selling takes hold. Actually, since 1980, May has posted a solid 64% "win" rate. The trouble begins to appear during the first partial summer month; since 1980, June has posted positive gains only 52% of the time. June looks impressive next to July which posted a win rate of 42% during the same period. Reversing the July pattern, August has logged 19 wins and 14 losses since 1980. That works out to a 57.6% win rate. But on a capital appreciation basis, August, like June, is fractionally negative. And finally, the worst of the bunch is September. The S&P 500 has been up 16 times and down 17 times since 1980 in this partial summer month, for a sub-par 48.5% win rate. I am not purporting that investors make rash decisions to avoid the possibility of a summer sell-off. But, it is worth noting that now is no time to get complacent.

Should we get a summer selloff, it likely will not be a bad thing. Since the bulls took control in spring 2009, the market has come strongly out of its summer doldrums. The fourth and first quarters, which are usually strong, have been better than average since the 2009 bull market began. Corrections serve the worthwhile aims of swamping unworthy names lifted by the bull market's indiscriminate rising tide; they also enable fence-sitters to come into the market at slightly more favorable price points. Still, there is a good chance this market can dodge the summertime blues and continue its formidable ascent. Improving the odds is the current rotation away from defensive stocks with a bend towards cyclical and risk-on categories.

Our conclusion, at least in the short-term, advises caution given the negative headlines and potential for increased market volatility. Still, the U.S. equity bull market appears intact and with long term trends pointing higher. Overall, we believe that growth potential for the U.S is supported by an uptick in manufacturing competitiveness, the housing rebound and energy independence. Despite the many positives, we anticipate a summer selloff; in fact we would welcome it. Like many previous summer swoons, a modest correction may be just the thing to kick this bull into high gear for a strong year-end finish.

Technical Perspective: Technical analysts, or Technicians, are taught to recognize a change in trading activity or trend. Irrespective of positive or negative connotations, a deviation from historical trends merits caution. I cannot argue that the S&P 500's uptrend is firmly intact and poised to continue its winning ways. However, it is worth noting that the recent vertical run is out of character from the pace of the uptrend going back to 2012. Our technical indicators are stretched; readings have maxed out at the top of their respective scales, and the VIX (considered by many as a fear gauge) is no longer going down despite all-time highs in several market indices. We view these irregular trading patterns as warning signals that must be confirmed by other metrics. So far, the S&P 500 continues to trend upward at an unnatural 45 degree-plus angle, picking up speed after the early May breakout through 1,600. The spread between the major moving averages is widening once more, signifying a strong increase in momentum - and the fact that there have only been three (small) red trading days this month exemplifies the recent surge of bullish sentiment.

For you die-hard technicians, the "Hindenburg Omen" created by James Miekka, the Hindenburg Omen warns of potential weakness in the stock market. There are three criteria to activate the omen. First, NYSE new highs and new lows must both be more than 2.8% of advances plus declines. Second, the NY Composite is above the level it was 50 days ago. Third, the number of new highs cannot be more than double the number of new lows. The activation period is good for 30 days. Once active, a sell signal is triggered when the McClellan Oscillator moves below zero and negated when it moves back above zero. Friday's big drop triggered the Omen signal for the second time in two months. Along with many other negative short-term signals, chartists can add one more reason to remain cautious.

Another indicator that we monitor is the yield curve and the current interest rate environment. The Fed's policy of keeping bond yields at unprecedented low levels has created a bag of mixed results. Ultra low rates force investors to look for higher yields in stocks (especially those that pay higher dividends). Simultaneously, the Fed has kept bond prices from falling (low bond yields support bond prices) through purchasing its own paper. Because of this, it is likely that a bond bubble has formed. Once the Fed decides to let bond yields follow their normal course [higher], bond yields will increase and bond prices will subsequently fall. Our bond charts have shown a recent upturn in bond yields and may be suggesting the Fed is loosening its grip on bond yields (or the market believes it may start tapering bond purchases). Either way, rising rates should accelerate the long-awaited "great rotation" out of bonds and into stocks.

The daily MACD has turned bearish and may prove troublesome in the short-term while the longer trending MACD points to more bullishness ahead. In fact, MACD couldn't be much stronger. As the markets continued hitting new highs almost daily, Bullish Percent Indexes have reached record highs and momentum has never been higher. Looking at the trends, long term investors should do well to stay invested. However, things may not be so easy as we navigate the summer selling months. Should markets rally this week and reach new highs, a negative divergence will unfold and add further pressure to the impulsive selling which took place last Friday.

Earlier in the year, as the S&P 500 approached 1,600 and our technical data suggested imminent retracement. Resilience triumphed and the markets maintained their velocity. The fact that earnings remain flat and top line growth is mostly flat, one would expect that something's got to give. At this point, rather than a small pullback, we are watching for signs of capitulation; a sharp volume spike, or a rise in VIX futures, for example. Last week we saw a significant spike in the VIX and it continues to move higher. Should more selling ensue, I would keep an eye on this simple gauge for points of entry. During the last year, virtually every short-term bottom on the S&P 500 occurred when the VIX traded between 18 and 21. Short of these significant signals, the trend appears up. However, we remain doubtful of further upside without some healthy reversal; several scenarios could produce a serious snap-back before continuing higher. Beyond what should be an inevitable retracement, the "great rotation" out of bonds will provide stocks with another opportunity to continue their bullish ways.

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