The S&P 500 (SPY) ended the week near the key 1,360 level for the fourth week in a row. We view the zone above 1,360 as bullish and the S&P 500 could rally up to the year-to-date high of 1,422 if it stays above this level. However, as stocks seem positioned to rally, the 10 year US Treasury is nearing its record high and seems positioned for a further upside move as well. In fact, the S&P 500 and the bond market have been moving in lockstep since mid-May, which is an unusual situation. This week the market has focused on earnings, which have generally come in in-line with much reduced analyst estimates, tough the theme seems to be "revenue misses, but EPS beat expectations." Also, Ben Bernanke spoke before Congress and expectations for QE3 are rising. In this update we will look at the recent price movements in the S&P 500 and other major indices as well as bond prices, review the S&P 500's valuation and macro news, examine "Risk On / Risk Off" indicators and present a bull and bear case for the market going forward as well as our investment plan.
S&P 500 and Other Major Indices
The S&P 500 closed the week at 1,362.66, corresponding to 136.47 on the SPDR S&P 500 ETF . After the Q4/Q1 rally ended, the S&P 500 traded in the 1,360 - 1,420 range (upper, green zone) and then in the 1,295 - 1,335 range (lower, red zone). Lately it has been moving indecisively between the two zones. Last week it seemed that the S&P 500 was moving into the upper zone, but it fell back on Friday with a 1% drop. Friday's drop could be attributed to a retreat from overbought conditions and, significantly, the S&P 500 still stayed above 1,360.
We will watch 1,360 next week. Many investors are watching 1,360 and may have put in orders around it, so the market may breach 1,360 to trap those investors. A small breach would not necessarily be bearish. However, if there is a clear breakdown below 1,360 then we would be more cautious over the short term.
The following are the year-to-date charts of the S&P 500 on a daily and weekly basis. The weekly chart more clearly shows how the S&P 500 has closed near the 1,360 level for the past four weeks.
(Source for all charts, unless otherwise noted: FreeStockCharts.com)
Another way to look at the chart is to focus on the rising channel since the June low.
The price movements in the Dow Jones Industrials Average (DIA), Nasdaq (QQQ), and Russell 2000 (IWM) were similar to the S&P 500, with a few differences. Most notably, the Russell 2000 does not seem to be holding up as well as the other indices. We have been looking to the Russell 2000 for clues since it is comprised of stocks of smaller companies and is a better indicator of risk.
In our update last week (Market Update: S&P 500 At A Crossroads As JPMorgan Offers Relief, Wal-Mart Hits New Highs), we called this market the "Wal-Mart (WMT) Market," because investors seem to be favoring large cap stocks with high dividends. We would prefer to see a stronger showing by the small cap stocks in the Russell 2000 as an indication of more risk taking.
Stocks vs. Bonds
There is an interesting relationship going on between stocks and bonds. The following charts compare the SPY to the iShares Barclays 20+ Year Treasury Bond ETF (TLT), which tracks U.S. bond prices. The first chart shows the SPY and TLT (white line) over the last year and the second shows the relationship on a year-to-date basis.
The first chart clearly shows that the SPY and TLT generally have an inverse relationship. However, since mid-May it seems that they are moving together.
The common way of looking at the relationship between stocks and bonds would imply that only one could move higher. However, it may be possible that both continue to move up.
The recent abnormal relationship between stocks and bonds may be attributable to Operation Twist. The Federal Reserve has been selling short dated bonds and buying long dated bonds. As a buyer of long dated bonds, the Fed is pushing up the price for these bonds and thereby reducing the yield, which is intended to help the economy by reducing the cost of long term borrowing.
The Fed announced the continuation of Operation Twist at its last meeting in late June. It is possible that the bond market is front-running the Fed's purchase of bonds and bidding up the price with the intention to sell those bonds to the Fed.
Additionally, the macro crisis of the last few months has created demand for US Treasuries as some investors are seeking a safe haven asset. So, the bond market may be impacted by specific dynamics that are distorting the traditional relationship with the S&P 500 and the stock market.
Stocks seem to be bouncing back as the European crisis is working itself out and 2Q earnings are not as bad as initially feared. There could also be some short covering as a result of earnings. It seems that the global slowdown is already priced into stock prices and a bit of good news could be a catalyst for an upside move in stocks, regardless of how the bond market moves.
Another key variable is QE3. Many investors are predicting, or hoping, that the Fed will launch another round of quantitative easing. The last two rounds of QE sparked rallies in the equity markets and this one could be a positive catalyst for stocks as well. Additionally, QE3 could further push up bond prices (and yields lower).
We do not know how all of this will play out, but the recent correlation between stocks and bonds is unusual and worth following.
S&P 500 Valuation
Eddy Elfenbein of Crossing Wall Street had a great post this week: The S&P 500 and Earnings. He shows a chart of the S&P 500 vs. earnings. Over time the S&P 500 seems to track earnings at a P/E multiple of 16. However, since 2011 the market has been trading below this multiple, indicating that investors do not believe that earnings growth will continue. Eddy says:
"If analysts are right and earnings start growing again, the market right now is very cheap. Under a reacceleration scenario, I think the S&P 500 could easily hit 1,500.
But if traders are picking up something not yet seen in the data, and the economy drops sharply, stocks could drop even further."
We like his analysis. If the bulls are right about the market, then their first upside target for the S&P 500 is likely to be the year-to-date high of 1,422. It seems reasonable that on a valuation basis the S&P 500 could reach 1,500 and if the market gets carried away then it would overshoot that level. These may be good levels to keep in mind if the market continues to move up. However, like Eddy says, if the economic situation deteriorates, then the valuation argument becomes irrelevant.
As mentioned above, Federal Reserve chairman, Ben Bernanke, appeared before Congress twice this week. Although he did not announce another round of quantitative easing, many commentators think the Fed will move in that direction. Bernanke said that the Fed is ready to take further action if the economy does not improve and said that progress on reducing unemployment is "frustraitingly slow."
There were some important developments in Europe this week. The German parliament voted to approve the bailout of Spanish banks by a big majority, helping to move that process forward. However, it seems that the situation is Spain is getting worse, as its Valencia region is reportedly preparing to ask the Spanish government for a bailout.
The European crisis is far from over, even if US investors have turned their attention to other things.
Finally, the IMF reduced its outlook for global growth (Weak Global Recovery Depends on Progress in Europe and United States)
Risk On / Risk Off Indicators
Other asset classes are giving a mixed picture for the S&P 500 and US stocks. On the positive side, the VIX - CBOE Volatility Index (VXX) dropped and the price of oil is up. On the negative side, bond yields in Europe continue to rise and the Euro is down.
Starting with the good news, the VIX closed the week at 16.27 and has remained below 20 for all of July. The low VIX could help set the stage for a market rally. However, it may make sense for investors to go long volatility at this level as a hedge against the macro situation.
Furthermore, the price of oil is continuing its rebound. However the rise in oil prices may reflect a risk premium because of the situation in Iran and Syria. It is hard to tell if oil is rising on increasing demand or increasing fear.
The Spanish bank bailout process made progress this week with the vote in the German parliament, but the 10 year Spanish bond yield reached a new record high and closed the week at 7.27%. Spanish bond yields may stay elevated until the funds from the bailout reach banks that would then buy Spanish government debt. However, if investors thought that demand for Spanish debt would come from the banks they would likely frontrun the banks and buy the bonds at the currently low prices (high yields). It seems that this is not happening. The rising yield on Spanish debt indicates that there is still grave concern about the situation in Spain.
Similarly, the 10 year Italian bond yield is also elevated and closed the week at 6.17%
Concern over the European situation is also seen in the currency markets. The Euro made a new low this week and closed at 1.2155.
The Bull Case
The market has dealt with a lot of bad news recently, but seems to be rebounding. The crisis in Europe seems to have passed its critical phase for now and bad news on the European front is priced in. A global slowdown and lower earnings growth also seems to be priced in. Investors are willing to bid up stocks even with the "revenue misses, but EPS beat expectations" theme from 2Q earnings so far. When bad news is priced in and everyone is bearish, scared or on the sidelines, the market may be positioned for a rally. The market does not need a lot of good news to move up with low valuations.
Furthermore, many commentators see the chances of QE3 increasing. There is also the possibility of stimulus from the Chinese government.
If the S&P 500 can remain above 1,360 then it may be on the cusp of a move up to 1,420 or further.
The Bear Case
The market is still facing several significant headwinds. 2Q earnings are not impressive and may lead to lower estimates for 2H 2012. The Fiscal Cliff is still looming and the European situation has not been resolved. Any of these could be a catalyst for a sell off. Furthermore, a lot more companies are going to announce their 2Q results in the coming weeks and the odds are that there will be more disappointments than positive surprises.
We are not sure about the stocks vs. bonds debate. We think that it is possible that both continue to move higher, especially if the odds of QE3 increase. The dynamics in the bond market are so abnormal, that we do not necessarily think that if bonds move up, stock must drop.
As we have mentioned over the last few weeks we favor the bullish case. We have been buying stocks, but doing so slowly to reduce risk. Our approach to earnings season has been wait-and-see. We reduced some positions going into earnings because we did not want the risk of earnings disappointments. However, we repurchased some of those positions after earnings came out and the results were good enough.
We are closely watching the 1,360 level on the S&P 500 for indications about the short term. If the S&P 500 can stay above that level we will likely increase our long exposure. However, we may cut it quickly if there is a big drop through 1,360. In this environment we are maintaining a strict stop-loss policy to protect our portfolio. We are willing to take some bullish bets, but want to make sure that our downside is limited.
Disclosure: I am long WMT.
Additional disclosure: We may trade any of the stocks/ETFs in this article in the next 72 hours.