The past couple of weeks the US indices have found themselves in a rather tight range as investors seek direction for the remainder of the year. Recent worries have multiplied to constitute a wall of worry (oil, US election, China economy, US lack of growth etc..), and yet the markets are still close to all time highs. A sign of resilience, one would hope.
I decided to start compiling indicators for various aspects of market behavior and to use them to provide guidance for trading directions. I sorted the indicators from long to short term, and listed them under the headings shown in the table below.
The color coding is my interpretation of whether the segment is positive for credit spread trading.
Economy: The US economy is still growing, albeit at ~2% YoY, and there is no recession in sight. Lots of arguments about where GDP is going to go in the next few quarters, but for now the economy poses no significant risk to the markets. The only potential fly in the ointment is the Fed. appears to be reducing reserves it holds i.e. decreasing liquidity. This may push the US$ higher.
Credit Markets: No sign of systemic risk; spreads for high - yield and corporate securities are well within their historical range. The yield curve (10year - 3 months) slope is increasing, consistent with minimal recession threat. The TED spread is high, but this may be more due to regulatory changes than indications of systemic risk.
SPX Earnings: Q3 is shaping up well. It's probable Q3 will see the end of the earnings recession. Guidance for Q4 also suggests corporate profits and revenues will continue to increase through the end of the year. Factset has a nice summary this week.
Breadth: This area clearly indicates the US markets (SPX, COMPQ) have weakened appreciably over the past few weeks. Across all measures of breadth - highs/lows, Up-down volume, advance/decline, moving averages - strength has decreased. These indicators are now at levels consistent with previous intermediate-term lows. Monitoring breadth for signs of deterioration is important, since it will likely signal a larger move down.
Sentiment: This is a mixed bag. Price action for SPX suggests neutral sentiment on the daily charts, but a more negative view on a weekly basis. Option and futures positions are on balance poised for upside, so trader positioning suggests a more positive view.
My interpretation of the dashboard is the current range bound price is likely to remain until a catalyst emerges. On the positive side, this is likely to be earnings, and if the positive start to Q3 continues, this will dispel the earnings recession meme. There are a multitude of potential negative catalysts, but the most likely is the result of the US elections (Presidential/Congress/Senate) in a couple of weeks time. The lack of breadth and wobbly sentiment implies the markets will be vulnerable to a negative shock, so it's wise to have some protection for option credit spreads.
Summary of Recent Economic/Market Events: Ritholtz
Economy and Market Action Summary: Fear and Greed Trader
Credit Spread Positions
ESZ16: The past couple of weeks ES has been forming a series of lower highs; a little worrying since the decreasing right angle triangle pattern has a tendency to break negatively. Nevertheless, support at 2112 has held. The rising trend line from Feb. is providing support currently at 2130. The indicators are neutral, even MACD, and so provide no guidance. Resistance is at the 50MA, which has started to dip down, and is now at 2152. Next week is big for earnings, and my guess is ES will take its cue from that action. However, it will take a clear negative picture to get ES through 2112, and then to 2100. The next support level is at 2075. My planning is for short put strikes at or below 2075, and paying close attention to the market this week to be ready to adjust if necessary.
RUT: Price action for RUT is mirroring ES, with a descending right triangle evident. However, the small caps have weakened more than ES over the last week or so, and RUT is no longer leading SPX. This is a sign of the poor sentiment currently in the market. The uptrend from February is supporting price and RUT spent the last week more or less crawling upward along the support line. At least it has not broken down, yet. A clear dip below 1218 will likely bring price down to 1200 quickly, which has reasonable support. This would be close to a 2% drop, and probably will hold up RUT at least in the short term. On the upside, 2136 is the resistance from the downward sloping trend. The indicators are more negative for RUT than ES, with RSI(5) below 50, and the stochastics still oversold, but looking like a bearish crossover could easily happen. MACD is negative but stabilizing. None of this points to obvious upside potential early in the week. As a result my own trading has been oriented to using short put strikes at as low a value as I can; fortunately RVX is elevated (~19), which helps push up option premiums. Longer term support is in the range 1160 - 1140. The 200 MA at 1140 should provide strong support in a worst case scenario for next week.
So far this month all of my trades have worked well, and expired OTM. For ES I have moved down put short strikes from 2100 to 2075 and 2050. The latter 2 strikes are feasible on intraday down turns, which have been quite obliging over the past 2 weeks. Similarly I have moved RUT short put strikes down to 1160 and 1140. I'hoping these strikes are sufficiently conservative to be trouble free next week. I'll look to open new spreads for the first week in November by mid-week once I can see how the US markets are moving. I have now closed the iron condors I had open, and the profits from these were very good. With the market dipping down to 2112 on ES earlier in the month I was able to open ES and RUT iron condors for mid-November expiration. I managed to get an insane deal on EW2 with a very small margin requirement. Potential profit on that beauty is 100% if I can hold it to expiration. I have not seen that kind of trade return before. Profit for October will be excellent if I can hold on for OTM expiration by the end of the month.
Hedge Strategy (Paper Trade)
The week before last proved to be very challenging for the SPX short put trade, which I had set up with a 2145 strike. Unfortunately SPX closed at 2133. Closing that big boy left me with an unpleasant tasting loss, so I decided I would try to recover rather than eat it. Recovering SPX losses are a little more problematical than equity or futures trades since SPX is a cash index i.e. no shares are assigned for an ITM short put. I switched the recovery to futures and bought 4 ESZ longs on 10/14 at 2126. The strategy was to let ESZ appreciate to 2140 or so, which would get me back my loss. However, looking over the price action that weekend, I decided it might not be wise to hope for ESZ to appreciate all the way; instead I sold short calls against the long futures with a strike price of 2130, which seemed more easily attainable than 2140. With a premium of $12.5 this got me an equivalent return to ESZ reaching 2140. This strategy worked well last week since ESZ only got to 2134. I made a decent profit for the week, and then opened up a new short call at 2115 for 10/28 expiration. Overall, the strategy continues to work well.
Reading list: 2 weeks worth, so lots of links.
Transports are heading up, defensive to cyclical rotation underway. Fund flows are negative. Sentiment is negative and earnings are set to surprise to the upside. And yet despite the plethora of bad news markets are still near their highs. Expect markets to improve through the end of the year. https://seekingalpha.com/article/4011124-investors-rotating-income-generating-equities
Some thoughts on the validity of ratio analysis for stock charts. Unclear what HYG is signaling now. http://jlfmi.tumblr.com/post/151628933300/spotless-indicator-signaling-btdor-has-its
Monetary base and the economy. A more complex topic than presented here, but perhaps the essence is reasonable. https://seekingalpha.com/article/4011274-fed-playing-didgeridoo-u-s-monetary-base?app=1&uprof=45&isDirectRoadblock=false
Long indicators are positive, as are most short indicators. Coincident indicators are mixed. Slow growth ahead. http://community.xe.com/blog/xe-market-analysis/weekly-indicators-slight-darkening-picture-edition
Retail sales show a new ATH. Sales leads jobs, and YoY sales is slowly decreasing. The implication is that jobs will slowly decelerate in the coming months. Rate hike anyone? http://bonddad.blogspot.tw/2016/10/september-retail-sales-positive-with.html?m=1
Several suggestions Q3 earnings will disappoint. Basis is apparent economic slowdown. Interest rate increase is a concern. This perception may be a form of recency bias since high freq indicators may be stabilizing. Bottom up analysis indicates more positive view: USA $ has stabilized, oil price improving. Forward earnings estimates continued to improve. Q3 so far is beating expectations. Interest rate <5% are correlated with increases in the stock markets - growth vs interest expense. https://humblestudentofthemarkets.com/2016/10/16/q3-earnings-season-stud-or-dud/
The Schiller CAPE may not provide as reliable a measure of valuation as commonly perceived. Changes in GAAP standards may have lowered earnings estimates recently compared to historic data. Using BEA corporate profits and Fed estimates of total market value adjusted CAPE is 19, not significantly above median. http://www.wsj.com/articles/powerful-market-indicator-flashes-sell-heres-why-it-can-be-ignored-1475687806
ECB is mulling reducing QE. Probably contributing to market weakness and increasing bond yields. https://espresso.economist.com/dfd786998e082758be12670d856df755
Labor force growth will be slow in the future as USA population growth slows and working population slows, despite likely baby boomers continuing to work. Productivity growth is likely to be around 1.5% YoY, which is typical outside of times where new innovations have max effect. As a result the current level of GDP growth is likely to persist until productivity jumps. Lower for longer seems to be the paradigm. http://ritholtz.com/2016/10/new-normal-us-growth/
Not an easy read but the essence seems to be that the amount of money in circulation as cash to be used by me and you has not really increased beyond what might have been expected from an extrapolation of pre-crisis trends. All the QE money is sitting as bank reserves at the fed picking up interest. A taxpayer subsidy of the USA banking system. Nice for some.
Economic growth is driven by expansion in the private sector, usually via borrowing, the government by deficit spending, or from inflows of foreign capital. During the 1990s the USA government ran a surplus, while foreign flows were minimal. The private sector drove the economy with an expansion of debt. The government surplus was not sustainable as it detracted from economic growth. The author suggests a Clinton presidency will be an economic problem because of the emphasis on deficit reduction. This is a time for the government to run a larger deficit to promote growth.
China's economy appears to be on solid footing. GDP has stabilized and the transformation to a consumer society is continuing. The industrial sector remains weak and government support is a problem. http://www.businessinsider.com/it-looks-like-chinas-great-slowdown-is-over-for-now-2016-10?pt=385758&ct=Sailthru_BI_Newsletters&mt=8&utm_source=Triggermail&utm_medium=email&utm_campaign=email_article
YoY comps will be easier in Q3 and Q4. Expect continued earnings growth with SPX returning over 10% in 2016. https://seekingalpha.com/article/4012384-big-jump-s-and-p-500-forward-4-quarter-eps-growth-rate-s-and-p-500-earnings-yield-6-percent?app=1&uprof=45&isDirectRoadblock=false
Alternatives to CAPE. Following the recent WSJ analysis with improvements to the calculation. Ed uses quarterly corporate profits and USA market valuation with foreign companies removed. All adjusted measures suggest markets are closer to fair value than overvalued. Markets do not collapse due to overvaluation; this requires earnings to reduce. So far earnings signals suggest improvement. http://blog.yardeni.com/2016/10/cape-fear.html?m=1
NDD lays out concerns for the longer term health of the economy. Long leading indicators are not signaling increasing strength. Rather a weak economy. Short and coincident indicators are mixed. The economy is not near recession but is vulnerable to a shock. Wage growth is low so a recession may lead to wage deflation for several years afterwards. Ouch. http://bonddad.blogspot.tw/2016/10/the-darkening-skies.html?m=1
The unemployment rate has stabilized and may now be increasing. However, under the current circumstances this does signal and impending recession. The increase is caused by greater participation i.e. More people deciding to work. This time around the unemployment rate may not be a useful signal of recession.http://scottgrannis.blogspot.tw/2016/10/chart-updates.html?m=1
A collection of Charts from Scott Grannis:
1. Money demand: he world wants to hold more cash relative to nominal GDP than ever before. People everywhere are more risk averse; caution permeates our daily lives; uncertainty abounds. "...it was the public's increasing demand for money that essentially forced the Fed to adopt Quantitative Easing. The Fed needed to increase the supply of money in order to satisfy the world's huge demand for money. Otherwise we would have experienced deflation, which is what happens when there is a shortage of money."
2. Inflation: headline will return to the 2% long-term average as oil price increases
3. Oil Price: Currently close to its long term average.
4. Swap Spreads: US close to perfect, EU higher due to bank uncertainty. No issue with liquidity as interest rates increases since the Fed now pays interest on reserves to control interest rates.
5. Swap spreads usually lead other spreads e.g. HY spread.
6. Corporate spreads are about average but off lows - investor caution evident.
7. SPX current P/E not far above average. Using NIPA profits (avoids GAAP problem) PE is are pretty much to at long term average.
8. Rule of 20: SPX PE+Core PCE deflator = 22. This measure says stocks are on the expensive side. Fair value = 20.
9. Equity Risk premium: high. "Investors today are willing to pay $57 for a dollar's worth of annual earnings on T-bonds, but only 20 or so for a dollar's worth of corporate earnings. Wow. If this isn't risk aversion I don't know what is. In effect, the market is saying that it is extremely unlikely for corporate profits to maintain their current levels for the foreseeable future."
10. Vehicle miles drive: Increasing thanks to low oil price. " Consider: if today's oil price has boosted the public's willingness and ability to use their vehicles, might it not also boost the economy's ability to grow?"
11. Chemical activity is picking up. This is a good leading indicator for industrial production.
12. TIPS yields track GDP. "The current relatively low and stable level of real yields suggests the market holds out little or no hope for any meaningful improvement in economic activity in the foreseeable future."
13. Yield curve is positive. Real yields on cash are negative. "The market fully expects the Fed to raise short-term interest rates, probably by 25 bps at the December FOMC meeting, and perhaps once more sometime next year. But even at 1%, the real funds rate would be zero or negative, and the yield curve won't become flat or negative until the market realizes that the Fed has tightened so much that its next move is likely to be to cut rates. Thus, tight monetary policy is still years in the future, barring an unexpected surge in economic growth and/or a surprising rise in inflation, either of which would force the Fed to become more aggressive."
The Fed is removing reserves from the bank system slowly. Working base i.e. money in circulation is still increasing. "As expected the draining of the total monetary base has resulted in the relative strengthening the U.S. dollar, a weakening of gold and commodities measured in U.S. dollars with the exception of oil which, of late, has been influenced more by the actions of OPEC and Russia. The bond market has been held in check by its more attractive yields than those available abroad and should remain so." The DJIA continues to be extremely attractively priced with its record dividend per share yielding more than the U.S. 30-year T Bond. A situation that has happened only three times over the past 40 years and more. Once earnings stabilize, expect a melt-up.https://seekingalpha.com/article/4013247-fed-contraction-monetary-base-much-important-hike-0_25-percent
Real income is decreasing as inflation, driven by oil price, increases. Since consumer spending is 70% of the US economy, this will be a major drag on the economy. Expect 1% growth for this year. https://seekingalpha.com/article/4013114-important-economic-data-point-running-empty?app=1&uprof=45&isDirectRoadblock=false
Inflation on track for 2.5% YoY. https://seekingalpha.com/article/4013811-track-2_5-percent-inflation-december-2016-update-october-2016
John Hussman holds forth with a familiar theme of low forward returns and likely catastrophic crashes as he views the current environment becoming skewed to risk aversion. Main points are the the only real wealth is associated with hard assets; all else is speculative paper gains. The Fed will not be able to sustain the markets if investors decide to adopt risk averse attitudes e.g. see 2000 and 2008. Current market fluctuations are similar to 2007 and are consistent with a top formation. https://seekingalpha.com/article/4012539-calm-storm
Despite recent market action, the longer-term charts suggest the price decrease are consistent with normal price action associated with Fib. retracement levels. No obvious signals that bearish sentiment has become dominant. https://seekingalpha.com/article/4011768-time-throw-bullish-towel
Oil prices have been talked up by OPEC without any agreement of production cuts. It's unlikely that production cuts will actually occur. This is a problem since speculative longs in oil are crowded, a situation that has negative implications for SPX should the longs unwind in a hurry, as they will in no production agreement is forthcoming. https://seekingalpha.com/article/4012961-technically-speaking-can-market-hang-support
Interest rates are now oversold. There is some doubt that the future economic growth that is driving up rates will actually occur. So, bonds are a good bet at the present. Moreover, increasing rates are front-running the Fed. With weak economic growth (Fed officials think current rates are an aberration and will quickly increase next year), a stronger US$ and increasing loan defaults it is unlikely the Fed. will manage to raise rates in December. https://seekingalpha.com/article/4012961-technically-speaking-can-market-hang-support
Additional disclosure: Don’t mistake anything you see here for investment advice.