What’s Wrong With This Picture?

Friday, April 26th, 2013

by Bespoke Investment Group

The chart below compares the S&P 500 since the beginning of 2009 to the weekly bullish sentiment reading from the American Association of Individual Investors (AAII).  The two lowest readings in sentiment during this period came on 3/5/09 (18.92%) and 4/11/13 (19.31%).  If you look closely at the chart, the level of the S&P 500 during these two weeks couldn’t have been farther apart.  In early March 2009, the S&P 500 was trading at multi-year bear market lows, while on 4/11/13, the S&P 500 closed at an all-time high.  In other words, investors were as bearish at the depths of the financial crisis as they were when the market hit an all-time high, and that pretty much sums up the state of sentiment during this entire bull market.

Over the last two weeks, we have seen a modest rebound in bullish sentiment, which now stands at 28.29%.  However, even after the rebound, bullish sentiment is currently lower than it has been in more than 85% of all prior weeks during this bull market, and it’s well below the average of 37.8%.

Copyright © Bespoke Investment Group

Tags: Aaii, Bespoke, Investor Sentiment, Sentiment
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Follow the ETP Flows: Corporates Rule

Wednesday, July 18th, 2012

by Dodd Kittsley, CFA, iShares

One of the advantages to working for the largest exchange traded product (ETP) provider in the world is that you have a lot of data at your disposal.  In my role as the Global Head of ETP Research for BlackRock, I deal in data every day, particularly as it relates to the in- and outflows of the 4500+ global ETPs currently in existence.  As you can imagine, examining flows can be a great way to spot investment trends, take the temperature of the market and reveal sentiment shifts.

Right now, for example, global ETPs just experienced their largest first half inflows ever.  ETPs attracted net new assets of $105 billion during the first half of 2012, representing a 16% increase on the $90.6 billion of flows posted during H1 2011.  Total industry assets now stand at nearly $1.7 trillion.

Not surprisingly, fixed income ETPs were a main driver of growth.  As global markets continue to be volatile, investors have increasingly been using these products to capture new and diversified sources of income.  Fixed income ETPs attracted 41% of all inflows with $42.0 billion on the year, or 114% above 2011’s comparable YTD figure of $19.6bn. In fact, June was the 18th consecutive month in which global fixed income ETPs have attracted net inflows.  Total assets invested in fixed income ETPs now exceed $300 billion and account for over 18% of total industry assets.

But here’s something you might not have guessed – within fixed income, investment grade corporate ETPs were the clear leader, bringing in $15.5 billion.  Throughout this year, investors have consistently committed new money to the category, with monthly flows ranging from $1.7bn to $3.2bn.  It appears that many investors may agree with Russ K’s feeling that investment grade debt is the place to look for relative safety (albeit less than Treasuries) with the opportunity for positive real yield.

So what do we think is in store for the second half of the year?  Well, if volatility remains an issue (and Russ K believes it will), we expect to see the flows into fixed income ETPs continue (see chart below).  In fact, if they continue to follow their current trajectory, FI ETPs could actually sextuple their assets over the next 10 years – from $300 billion to $2 trillion.  As my colleague and fellow blogger Matt Tucker has said many times, investors are starting to realize that fixed income ETPs are simply a better way to invest in bonds.

Fixed Income Cumulative Net New Asset Trends

Never one to keep a good story to myself, I’ll be sharing interesting ETP flow data and related insights on a regular basis here on the iShares blog.  And I’d love to hear from all of you – what questions do you have that our data might be able to answer?

Source: BlackRock Investment Institute

Tags: Assets, Blackrock, Cfa, Corporates, Diversified Sources, Dodd, Etps, Fixed Income Investment, Global Head, Global Markets, Investment Trends, Ishares, Nbsp, New Money, Relative Safety, Russ, Second Half, Sentiment, Treasuries, Trillion
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Month of May: Sell and Go Away, or Hang in There? (Sonders)

Tuesday, May 15th, 2012

May 14, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• We believe the stock market’s correction is likely to be less severe this year relative to 2010 or 2011.
• Be aware of the possible perils of following a “sell in May” trading strategy.
• For now, macro concerns—including Europe and the looming “fiscal cliff”—are trumping better micro news.

The stock market is in correction mode and investors are on edge. There are likely several reasons for the weakness, including what we pointed out in our early-April report on elevated optimistic sentiment. Since sentiment tends to work a contrarian magic on the market, we were anticipating a period of consolidation after the stellar six-month, 30% run off the early October 2011 low—and we’re getting it.

Of course, we’re also yet again dealing with the eurozone debt crisis, but also choppier economic indicators in the United States recently, a volatile election season and concerns about the so-called “fiscal cliff” heading into the end of this year. But one of the questions I’ve gotten most often recently has been about the seasonal phenomenon called “sell in May and go away,” and whether the market’s in store for another summer swoon like we’ve had the past two years.

Macro trumping micro

I’ll start with “sell in May,” but before I do, I want to address an important general observation. As we’ve noted many times recently in reports and media appearances; and as detailed in a terrific recent report by Wall Street research firm Wolfe Trahan, macro is trumping micro. One of the reasons for this is the decline in guidance investors are receiving from company managements.

In the past, guidance was often an anchor of reason in volatile times. Events like European elections or spiking eurozone sovereign bond yields might not have been such big market-moving events when we could rest on US companies’ guidance as to the future. Add to that rapid-fire trading, shortened time horizons, greatly increased access to information, greatly increased speed of news’ dissemination, and much more globalized economic and financial systems, and you have a recipe for increased volatility around macro events.

Sell in May?

Much is made every year of the “sell in May” phenomenon. Its basis is rooted in the fact that the best performance for the market has generally come in the November through April period, while the worst has come between May and October.

There is some truth to the adage. According to data compiled by Ned Davis Research (NDR), through the beginning of May this year the average performance for the period from May 1 through October 31 each year since 1950 was 1.2%. The average performance for the period from November 1 through April 30 each year since 1950 was 7.0%.

As compelling as those numbers may seem, there are many things to consider, especially if it’s your inclination to develop a trading strategy around those seasonal patterns. First, the calendar months individually tend to fall into either the “hot” or “cold” columns for performance, as you can see in the table below. Three of the six months that fall into the “all out” period spanning from May through October are actually historically strong months, while three of the six months that fall into the “all in” period spanning from November through April are actually historically weak months.

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as of 1928-April 30, 2012.

As you can see, all of the seasons seem to be adequately represented in both columns. And what we know for a fact is that time horizons have become much shorter over the recent years, and the reaction function gets triggered more often. It’s likely that many investors may find their patience tested when experiencing either a great month (or two) during the May-October “all out” period and/or a poor month (or two) during the November-April “all in” period. Of course, the seasonal trading strategy must consider transaction costs and tax implications.

Sector performance May-October

For investors who like to take a tactical approach to the seasonal tendencies, a sector bias strategy may be worth considering. Before I get to the details, let me remind our clients that we moved toward a more sector-neutral strategy back in early April when we became more cautious about the market in the short term. Presently the only outperform rating we have is on the information technology sector, while the only underperform rating we have is on the utilities sector.

As you can see in the table below, courtesy of The Leuthold Group, cyclical groups have tended to outperform during the market’s traditionally strong November-April period, while defensive sectors have been the relative winners during the customarily weaker May-October period. In fact, the size and persistence of these effects have been impressive (at least since 1989, the span of the analysis).

S&P 500 Sector Seasonality

Source: The Leuthold Group, October, 1989-April, 2012. Defensive sectors: consumer staples, health care and utilities. Cyclical sectors: consumer discretionary, industrials and materials.

Buy in May in election years?

There’s also the rub of this being an election year, during which sitting out the May through October period has historically not worked well. Using the Dow Jones Industrial Average because of its longer history, the market has been up 4.5% during election years in the May-October span versus 2.6% for all years (including election years). And for what it’s worth, according to NDR, the market has bucked seasonal weakness even more when the incumbent president has won, with a median gain of 7.6% versus 0.5% when the incumbent president has lost.

NDR provides a clue as to why this is the case: A correction has occurred during the second quarter of election years, on average (sound familiar?). But the correction has tended to be concentrated in the second quarter, setting the stage for a summer rally.

2012′s positive offsets to present weakness

I actually think the scenario noted above is more likely than not this year. Muscle memory has many investors fretting a repeat of 2011 and 2010, when economic weakness in the spring led to brutal corrections each year, to the tune of -19% and -16%, respectively. But there’s a long list of positive offsets this year relative to the past two years:

• Inflation is coming down, especially among commodity prices.
• Credit growth is quite strong, especially for consumers.
• Housing has improved markedly.
• The US manufacturing sector is humming.
• NFIB’s small business survey made recent upside breakout.
• Job growth is much better.
• Consumer confidence is improving.
• Private-sector leverage ratios are much improved (debt servicing costs are extremely low).
• Recovery in state/local government spending.
• The US economy somewhat decoupling from rest of world; at least Europe.
• US bank capital/health is much better than Europe’s.
• The European Central Bank’s Long-Term Refinancing Operations have reduced likelihood of global financial contagion.
• Germany appears more willing to accept higher inflation, opening the door to easier monetary policy for the eurozone.
• Valuations are quite cheap, especially on forward earnings.
• Investor sentiment has improved sharply with the correction to-date (meaning pessimism has kicked back in).

I don’t think the present correction is over, but do believe it could be kept to within the normal 5-10% range. Since the current bull market began in March 2009, the S&P 500 has had 15 corrections of more than 5% that were preceded by at least a 5% rally (consistent with this year’s pattern). The table below highlights their duration and ultimate percentage drop.

S&P 500 5% Corrections

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as of May 11, 2012.

Wall of worry being rebuilt

Tempering my short-term concern has been the aforementioned improvement in sentiment conditions. That said, I think there’s likely a bit more pessimism needed to establish a short-term bottom for the market. As you can see, the well-watched NDR Crowd Sentiment Poll (CSP) has moved decisively lower, but not yet to the extreme pessimism zone:

Bye-Bye Optimism

Source: NDR, Inc. (Further distribution prohibited without prior permission. Copyright 2012 (c) Ned Davis Research, Inc. All rights reserved.), as May 8, 2012.

NDR noted in a recent report several key reasons to expect the correction to be within the normal 5-10% range:

• Initial reversals in CSP extremes are consistent with median declines of about 8% within six months.
• The first half of election years have shown median declines of just less than 10%.
• Once “pre-waterfall” highs have been exceeded, as occurred in February of this year, median market declines have ranged between -3% and -7% within six months.

Saving the worst for last

I think investors and the media may be underestimating the impact the coming “fiscal cliff” is having on market and business psychology. The fiscal cliff refers to the near-simultaneous January 2013 expiration of the Bush tax cuts, the payroll tax cuts, emergency unemployment benefits and the sequester (automatic spending cuts) established in last summer’s debt-limit agreement.

The range of estimates for its ultimate impact are, unfortunately, quite wide. The lowest estimate I’ve seen comes from NDR, using Congressional Budget Office assumptions, with the impact at a relatively “low” 2.4% of US gross domestic product (GDP). Most estimates tend to cluster around 3.5% of GDP.

It’s impossible to know what’s right because different assumptions are being used. But the consensus is closing in on a worst-case scenario of about 4% of GDP. ISI recently put the numbers into three distinct buckets, each with about $200 billion of impact:

1. Provisions likely to create a fiscal drag (approximately (≈) $221 billion or 1.4% of GDP):
   • Cuts to discretionary spending (≈$84 billion)
   • Tax increases on upper-income Americans included in the Affordable Care Act (≈$21 billion)
   • Payroll tax cut (≈$116 billion)
2. Bush tax cuts (≈$200 billion or 1.3% of GDP, although likely impact would be spread over several years)
3. Items unlikely to be allowed to take affect and thus aren’t likely to create a fiscal drag (≈$179 billion or 1.1% of GDP):
   • Huge increase in number of Americans paying the alternative minimum tax (≈$94 billion)
   • Sequester cuts (~$85 billion)

There are three additional items that don’t fall neatly into ISI’s three buckets, including tax extenders, extended unemployment insurance benefits and the “doc fix,” which would together total about $75 billion. These items are not expected to create a significant fiscal drag.

I actually think this is having a larger impact on psychology than many believe, especially on the confidence of corporate leaders and their ability to plan (and guide Wall Street’s analysts) for the future.

Muscle memory may fail us this year

In sum, there’s much to fret about, and volatility is likely to remain elevated until this correction has run its course. But a lot has changed in the past two years—much for the better—particularly for domestically oriented US companies. There’s at least a little bit of decoupling underway, certainly between the United States and Europe, and that’s likely to assist in keeping the correction from mirroring the ones in 2010 and 2011.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Tags: Anchor, Bond Yields, Charles Schwab, Chief Investment Strategist, Debt Crisis, Economic Indicators, Election Season, European Elections, Liz Ann, Media Appearances, Micro News, Perils, Seasonal Phenomenon, Senior Vice President, Sentiment, Stock Market, Swoon, Trading Strategy, Trahan, Volatile Times
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Dancing at the Edge of a Cliff (Hussman)

Sunday, May 13th, 2012

In recent weeks, I’ve emphasized that our estimate of prospective market return/risk in stocks has slipped into the most negative 0.5% of historical data (reflecting a range of horizons from 2 weeks to 18 months). Last week that estimate actually deteriorated, but I am reluctant to make comments on such a small sample, as the only more negative estimate in post-Depression history was on September 16, 2000. Even in the conditions that match the worst 2% of our return/risk estimates (which is the part of the tail we have been in since late-February), the market has lost an average of 20-25% just in the following 6-month period. As much as I try to maintain equanimity – focusing on the average outcome of a particular set of market conditions rather than the specific instance at hand – it is very difficult to do so at present.

The green bands in the chart below depict all of the points since 1980 in the neighborhood of present conditions – having a nearly similar prospective return/risk profile, coupled with a particularly hostile “exhaustion syndrome” that has been a hallmark of the worst market outcomes in recent decades. The blue line shows the S&P 500 Index. As I noted in Goat Rodeo, “what this combination picks up is an already fragile set of market internals that has enjoyed an ‘exhaustion rally’ that both exceeds earnings growth and is met with overbullish sentiment.”

I usually show longer-term charts, but there are no green bands prior to 1987. Before that point, valuations were never been as extended as they are today – on the basis of normalized earnings – except in the quarters leading up to the 1929 crash. Exhaustion syndromes prior to 1987, while still very hostile to stocks, didn’t occur in valuation conditions as rich as we have today. It’s worth noting that there is a very narrow band in 2006 that was followed by a decline of only a few percent, but even the seemingly benign instances in 1998 and early 2000 represented losses exceeding 10%. I suspect we’re at risk of something far more significant. Importantly, the drivers of our market risk estimates are largely independent of our measures of recession risk. This may provide some insight into why my concerns have become so strident in recent weeks.

Present market risks involve a confluence of factors. First, valuations remain unusually rich. Though prospective returns are better than at the 2000 and 2007 peaks, valuations remain more elevated than at any point prior to the late-1990′s bubble, save for the period before the 1929 plunge. Notably, valuations only seem “reasonable” on the basis of “forward operating earnings” if one ignores the fact that profit margins are 50-70% above historical norms, and are dependent on unsustainably large fiscal deficits and depressed household saving in order for that to continue (see Too Little to Lock In).

Second, market internals have deteriorated, with an uncomfortably familiar “two-tier” profile developing between a handful of speculative momentum stocks and the broader market. Coupled with an active new issues calendar, near-panic levels of selling by corporate insiders, heavy beta exposure among mutual funds and institutional managers, record-low mutual fund cash levels, and advisory bearishness at just 20.5% (a level last seen before the steep 2011 decline), there appears to be a lopsided exposure to risk among speculators, and a divestment among issuers.

Third, as I’ve frequently noted, the best way to extract meaningful signals and reduce noise in volatile data is to draw those signals from the joint behavior of several indicators. While these methods range from the simple to the complex, we’ve frequently presented variously defined sets of indicators (see An Angry Army of Aunt Minnies) that capture some particular investment environment (such as an overvalued, overbought, overbullish market where favorable drivers have begun to drop away). In recent weeks, we’ve seen several of these hostile syndromes emerge, as I’ve detailed in prior weekly comments.

Tags: Earnings Growth, Equanimity, Exhaustion, Goat, Hallmark, Horizons, Hussman, Instances, Market Internals, Market Outcomes, Present Conditions, Quarters, Risk Estimates, Risk Profile, Rodeo, Sentiment, September 16, Term Charts, Valuations, Worth Noting That
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Reading the Tea Leaves When There is No Tea (Tchir)

Tuesday, April 17th, 2012

by Peter Tchir, TF Market Advisors

Everyone is trying to figure out what is going to happen next. Investors are looking clues and signals as to the next big move. The problem is that liquidity is so poor, moves that might normally signal a shift in sentiment or risk, are now just noise.

We can look at 10 year Spanish yields. Definitely a useful signal, but back to exaggerated moves on little volume. Liquidity is abysmal.

Things like the EUR/USD basis swap was once an indicator, but how useful is something when the Fed has provided unlimited swap lines and banks are encouraged to use them. Hardly an indicator of anything, though I would argue any weakness in the face of all that central bank effort is more meaningful than signs of strength.

It was easy when the EUR/USD rate itself was a key indicator. Sometimes it still is, sometimes it isn’t. It is flow driven, but the flows are confusing as some money is just being shifted from one Eurozone country’s bonds to another’s, and there is growing confusion over what it means that each country’s debt is being held in an ever greater proportion by its own banks.

For myself, I’m looking more at yield curves than any particular bond. The curve flattening is still a bearish indicator, though Spain is a weird one today, where currently the 2 year yield is higher, the 5 year yield is better, but the 10 year is higher, though all have rebounded significantly.

CDS seems to remain a better indicator of the true state of the credit market, though the technicals from any potential “whale” trade unwind are hard to account for. I am seeing bid/offer spreads normalize in the U.S. which is a good sign, but they are still wider than normal in Europe. IG18 is basically unchanged on the day, in spite of the moves in stocks, another sign that the rally isn’t very deep yet.

The size of the moves in all markets is getting scary. We have now seen stock futures move more than 1% today from their overnight lows. Were the retail sales data really that good? Some of it looked strong, but the “core” numbers were less compelling. Empire manufacturing was bad. We are quickly heading back to a period where you need to have small positions, because news that would have caused a 0. 5% move in the market a couple of weeks ago, is now moving it 1%. Maybe today is somehow a turning point, but I don’t think it is, so we will see selling pressure into every rally as total return players have to “rightsize” their positions for the increased volatility. This is the real intraday volatility that investors experience as they do their intraday P&L estimates, not VIX or any other form of implied vol.

With no liquidity be careful reading too much into any move (positive or negative) but expect some weakness as these moves will force investors (hedge funds in particular) to make smaller bets.

Twitter: @TFMkts

Tags: Basis Swap, Bonds, Confusion, Curve, Eurozone, liquidity, Nbsp, Proportion, Rally, Sentiment, Signals, Spite, Stock Futures, Tea Leaves, Technicals, Tf, True State, Weird One, Whale Trade, Yield Curves
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Gary Shilling Still Looking for a Recession in 2012 Part I

Wednesday, April 11th, 2012

Gary Shilling has been more dour than most on the underlying economy the past 3-4 years, and that could be argued was a relatively good call.  Despite never before seen levels of federal government and central bank intervention, the economy continues to limp along at what I call a “meh” pace.  Normal recoveries sans massive intervention should have had some sustained periods of 4-5%+ type GDP growth; we’re happy with 2-3% nowadays.  Gary’s long U.S. Treasuries call has been against the grain, and mostly right the past few years, and he’s had quite a few other prescient calls as well.  Shilling posted 2 articles on Bloomberg, stating the case for a recession in 2012 – which is now again an outlier view.  We’ll look at part 1 today, and look at part 2 which focuses on the labor market tomorrow.

Here are some of his views as he looks at the main pillars of the economy:

• For several months, I’ve been forecasting a recession in the U.S. this year, arguing that weakened consumer spending – the key to the economic outlook — would tip the economy back into a downturn.  But what about recent positive data and markets? Do they affect my forecast?
• Consumers Are the Linchpin: The U.S. economy is being fueled these days by strong consumer spending, which increased in February by 0.8 percent, its best showing in seven months, after rising 0.4 percent in January. Retail sales rose 1.1 percent in February — the fastest pace in five months — while same-store sales advanced 4.7 percent. These numbers correlate with recent gains in consumer confidence and sentiment.
• I don’t see this pace continuing. Personal-income growth continues to be weak — up just 0.2 percent in February — meaning this recent exuberant consumer spending is being fueled largely by increased debt and tapping of savings.
• At the same time, pay per employee is rising slowly and continues to fall in real terms. So increased job growth remains the key to any increases in real household after-tax income, which declined in February for a second straight month and gained a mere 0.3 percent, compared with February 2011.
• Spending, Saving and Debt: The support that consumer spending has received from less saving and more debt appears temporary. Household debt – including mortgages,student loans, and auto and credit-card loans — has fallen relative to disposable personal income, though. In my analysis, this is largely because of write-offs of troubled mortgages. Nevertheless, revolving consumer credit, mostly on credit cards, is no longer being liquidated.
• Non-revolving consumer credit continues to rise in response to growing sales of vehicles — most of which are financed — and in student loans, as the poor job market keeps students in school or sends them back. Tuition increases encourage more borrowing, while interest costs on past-due loans mount.  [Mar 8, 2012: What Drove Yesterday's Surge in Consumer Credit? Massive Upswing in Federal Student Loans]
• It would seem, then, that contrary to my steadfast belief that consumers are being forced to save more and reduce debt to rebuild net worth, they have been doing the opposite lately.
• Consumer Retrenchment: The data so far aren’t conclusive, but evidence of U.S. consumer retrenchment is emerging. Consumer confidence has moved up recently but remains far below the levels of early 2007 before the collapse in subprime mortgages set off the Great Recession. Real personal consumption expenditures growth has been volatile in recent months and falling on a year-on-year basis. Voluntary departures from jobs, another measure of confidence, may be decreasing. And consumer spending will no doubt have a big slide if my forecast of another 20 percent drop in house prices pans out. (Mark’s note: that seems aggressive!)
• Housing activity remains depressed, with the only signs of life coming from the multifamily component, which is being driven by the appetite for rental apartments as homeownership declines.
• What Oil Threat?: Recently, there has been great concern about $4 per gallon gasoline and whether, as in 2008, those high prices will act as a tax on consumer incomes and force drastic cutbacks in other purchases.  These concerns are overblown. American consumers have reacted to rising gasoline prices as you would expect in tough times: by consuming less. Demand (DOEDMGAS) in the mid-February to mid- March four-week period was down 7.8 percent from a year earlier, mainly due to more efficient vehicles.
• As a result, the recent surge in gasoline prices has had a relatively small impact on consumer purchasing power. The $14.8 billion increase from October 2011 to March 2012, compared with the year-earlier period, amounts to about 0.3 percent of consumer spending.

Conclusion:

• Consumer spending is the only major source of strength in the U.S. economy this year. State and local-government spending remains depressed because of deficit woes and underfunded pension plans. Housing suffers from excess inventories and may face a further 20 percent drop in prices. Excess capacity restrains capital spending. Recent inventory building appears involuntary. So consumer retrenchment will tip the balance toward a moderate and overdue recession.

Tags: Bloomberg, Central Bank Intervention, Consumer Confidence, Downturn, Economic Outlook, Federal Government, Five Months, Gary Shilling, GDP, GDP Growth, Market Tomorrow, Massive Intervention, Personal Income Growth, Pillars, Recession, Retail Sales, Sentiment, Seven Months, Tapping, Treasuries
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Do I Feel Lucky? (Hussman)

Monday, March 12th, 2012

by John P. Hussman, Ph.D., Hussman Funds

As of last week, the market continued to reflect a set of conditions that have characterized a wicked subset of historical instances, comprising a Who’s Who of Awful Times to Invest . Over the weekend, Randall Forsyth of Barron’s ran a nice piece that reviewed our case (the chart in Barrons has a problem with the date axis, but the original chart is in last week’s comment Warning: A New Who’s Who of Awful Times to Invest). It’s interesting to me that among the predictable objections to that piece by bullish readers (mostly related to our flat post-2009 performance, but overlooking the 2000-2009 record), none addressed the simple fact that the prior instances of this syndrome invariably turned out badly. It seems to me that before entirely disregarding evidence that is as rare as it is ominous, you have to ask yourself one question. Do I feel lucky?

From our perspective, accepting stock market risk is not presently a venture that is priced to achieve reasonable investment returns (we estimate a likely 4.3% annual total return for the S&P 500 over the coming decade, and a great deal of volatility in achieving that return). Nor is market risk attractive on a speculative basis, given present overbought conditions, overbullish sentiment, and growing set of hostile syndromes (what we call Aunt Minnies) that have historically been associated with negative return/risk tradeoffs. Then again, what keeps slot machines spinning all around the world is the hope – despite the predictably and reliably negative average return/risk tradeoff – that this time will be different, and this spin will work out. So you have to ask yourself one question. Do I feel lucky?

Investors Intelligence notes that corporate insiders are now selling shares at levels associated with “near panic action.” Since corporate insiders typically receive stock as part of their compensation, it is normal for insiders to sell about 2 shares on the open market for every share they purchase outright. Recently, however, insider sales have been running at a pace of more than 8-to-1. Indeed, some of the weekly spikes have been to levels that are associated almost exclusively with intermediate market peaks, the most recent being the run-up to the 2007 market peak, the early 2010 peak, and the 2011 peak, all of which resulted in significant intermediate corrections or worse. Of course, it’s sometimes the case that insiders are early, and therefore miss part of the tail of a market advance. So it might be worth ignoring the heavy pace of insider selling for a little while. But you have to ask yourself one question. Do I feel lucky?

As disciplined investors who align ourselves with the average return/risk profile that is associated with prevailing market conditions, we don’t believe that this is a good time to take significant market risk in hopes of getting lucky. On an objective basis, we identify present conditions among the lowest 1.5% of historical periods in terms of overall return/risk profile. Maybe investors will get lucky, but the odds are still unfavorable.

It’s likely that for some investors, our defensiveness since 2009 bleeds into a general inclination to take our concerns about risk with a grain of salt. On that subject, it’s important to recognize that our defensiveness in 2009 did not result from unfavorable valuations or hostile indicator syndromes, but from the inability to distinguish prevailing conditions at the time from much of what was observed during the Depression-era. In response to the credit crisis, and what I continue to view as a misguided “kick-the-can” policy response, I insisted that our methods should perform well with reasonable drawdowns not only in post-war data, but also in Depression-era data (when for example, stocks lost two thirds of their value even after they were priced to achieve 10-year total returns in excess of 10% annually).

The resulting ensemble methods allow us to make distinctions that we were not able to make in 2009, but that period of stress-testing also left us with a “miss” (2009-early 2010) when the same indicators and methods that are so hostile today would have been much more favorable toward investment risk. One could ignore that fact, and use our miss in 2009 as a reason to ignore demonstrably hostile evidence today. But one would also have to overlook the fact that the narrow syndrome of conditions we observe today mirrors what we observed at the 2000 peak and the 2007 peak, and very few times in-between (including the 2010 peak and the runup to the 2011 peak – see last week’s comment for a chart). Notably, whatever market returns we missed by being defensive too early in those instances were wiped out in short order anyway during the subsequent declines. Yes, stocks might move even higher before the present bull-bear cycle moves to completion. But you have to ask yourself one question. Do I feel lucky?

A note on extracting economic signals

While investors and the economic consensus has largely abandoned any concern about a fresh economic downturn, we remain uncomfortable with the divergence between reliable leading measures – which are still actually deteriorating – and more upbeat coincident/lagging measures on which public optimism appears to be based.

Much of our research effort in recent weeks has been focused on developing a deeper understanding of this divergence. The historical evidence clearly indicates that such divergences are settled in favor of the leading indicators (see last week’s economic discussion in Warning: A New Who’s Who of Awful Times to Invest ), but since our views are so out of sync with the broad consensus, the issue demands as much additional investigation and research as we can amass. It bears repeating we neither desire a recession, nor have any interest in “pounding the table” about it. We would rather have the data convincingly shift to a condition that eases our recession concerns. But if we’re likely to have a recession, we don’t want to be surprised or lulled into complacency by improvement in what are largely lagging indicators.

Probably the best, if slightly technical, way to understand our reluctance to discard recession concerns is to think about observed economic data as being driven by a series of unobserved “true” states of the economy. For example, suppose that the true underlying state of the economy can be summarized by a single positive or negative number each month, call it X(t), and that each economic indicator we can actually observe is driven by a series of those current and past monthly economic states. So for example, some variable that we can observe might be written as a series of unobserved economic states:

Y(t) = a0*X(t) + a1*X(t-1) + a2*X(t-2) + …. + a “shock” from truly new developments and random noise.

[Geek's note - this is a version of an unobserved components model, of the kind used in nearly every modern signal-processing application. For example, when you go to the hospital to get a CT scan, the picture you see is not actually "taken" directly. Instead, the machine shoots X-rays at you from every possible angle, and then uses all of that sensor data to compute an image that could never have been obtained directly. That's why it's called computed tomography (CT). If signal processing methods weren't applied, every image of an internal organ would be obstructed by artifacts from bone, cartilage and other organs. Similar signal processing methods are used to combine data from multiple sensors in order to navigate anti-ballistic missiles and other objects that can't be directly observed (and of course, to identify meaningful genetic signals in autism data)].

Leading indicators essentially place weight on the unobserved true state a few months into the future (allowing that state to be estimated today based on those observed indicators), while coincident and lagging indicators load on previous components. To see what this looks like, the following chart presents the load factors we estimate for dozens of widely followed economic variables, including one-month, 6-month and year-over-year employment gains, new unemployment claims, real consumption growth, ISM data, consumer confidence, quarterly and year-over-year GDP growth, stock returns, credit spreads, OECD leading indices, and a score of other measures. Notice that most of the variables load not on the first (most leading) economic state variable, but instead on the fourth or fifth component. That’s another way of saying that most observed economic variables actually lag the best leading indicators by several months. A good example is year-over-year growth in payroll employment, which trails year-over-year growth in real consumption with a consistent lag of about 5 months.

So what do the unobserved components look like today? In the chart below, the green line shows the average standardized value (mean zero, unit variance) of dozens of economic variables, and provides a very good summary of what can be observed directly. Note that this observable data has enjoyed a clear bounce in recent months. The blue line presents estimates of the unobserved economic states that drive the observable data. Importantly, the extracted signals lead the observed economic composite by several months. This is really simply a reflection of the underlying structure of the data – leading indicators lead, and lagging indicators lag (the full analysis uses data since 1950, but the lead of a few months is hard to distinguish visually on a long-term chart).

The most recent estimates we obtain for the extracted economic signal (most recent first) are as follows:

Feb: -0.647
Jan: -0.603
Dec: -0.435
Nov: -0.189
Oct: -0.041
Sep: 0.075
Aug: -0.507
Jul: -0.603

What strikes me about these estimates is short-lived spike in the implied economic signal between September and November. My thinking on the recent improvement in economic data was that it was primarily driven by the large intervention by the ECB near the end of last year. But even when we estimate the parameters of the model using half the data set, and then run true out-of-sample estimates of the economic signal through the present, we still get that burst of improvement in the September through November period. What’s interesting about that improvement was that it was not driven by any obvious shift in the observable data. Rather, the spike was driven by the failure of the data to deteriorate during that period to an extent that would have been expected, given the trajectory of the economic state (this is similar to shifting your expectation for a bird’s flight path not because it turned, but because it failed to turn as much as expected).

In that context, we can see that the improvement in the observable data in recent months has faithfully followed the improvement in that underlying state, which actually happened months ago. Since then, however, the estimated state has deteriorated to a point that is now worse than it was last July.

This is important, because given the deterioration in the inferred economic condition between October and December, it follows that we would expect to see a clear deterioration in observable economic variables over the next 8-12 weeks. If the trajectory holds, the weakness is likely to emerge slowly and then accelerate. For example, the preliminary expectation would be for continued positive payroll growth in March (roughly 50,000-70,000 jobs) and a shift to net job losses in April.

Equally important, to the extent that we observe economic variables coming in better than expected, the inferred underlying state of the economy is likely to improve sharply, as it did last September. This will take a few months of data, but it’s not going to require quarters and quarters of it. At present, we have to view the economic situation negatively, but on the optimistic side, we should also be able to abandon our own recession concerns if the observable data move off of the trajectory that we’ve imputed to-date. On this, leading measures such as consumption growth and OECD leading indices will be most important in driving our estimates of future prospects, while the employment data over the next few months will be useful in confirming the downturn we’ve seen in the inferred state estimates since November.

Market Climate

As noted above, the Market Climate for stocks remains among the most negative 1.5% of historical instances. This time may be different. We see no reason to expect so other than the hope of being lucky. Still, one thing is certain, and that is that present conditions will be impermanent. With certainty, market conditions will shift in a way that removes the present syndrome of overvalued, overbought, overbullish conditions. We don’t know whether that shift will involve a moderate retreat that removes the overbought and overbullish aspects, or a major decline that removes the overvaluation, or just maybe with a further advance that then corrects enough to clear this syndrome at a higher level than the market is today. Conditions might improve without a major breakdown in market internals, or they may improve by a firming of market internals following an extended period of weakness. But with certainty, market conditions will shift in a way that provides us an opportunity to accept market risk at a positive and favorable expected return/risk tradeoff.

Also, with certainty, the present divergence between leading economic measures and coincident/lagging measures will also be resolved. While the historical likelihood is that the coincident and lagging measures will follow the leading measures, we also know that our estimates of the underlying state of the economy could shift quickly in the coming months simply in response to an economy that achieves moderate positive growth, and thereby deviates from what is now an unfavorable projected trajectory.

For now, Strategic Growth and Strategic International remain tightly hedged. Strategic Dividend Value is hedged in an amount equal to 50% of its equity holdings (which is the largest hedge the Fund can establish, but which also leaves the Fund more exposed to general market fluctuations in both directions). Strategic Total Return also remains relatively conservative here, with a duration of about 3.5 years in Treasury securities, and a very small percentage of assets in precious metals shares, utility shares and foreign currencies.

Copyright © Hussman Funds

Tags: Aunt Minnies, Barron, Barron's, Corporate Insiders, Hussman Funds, Instances, Investment Returns, Investors Intelligence, Objections, Panic Action, Selling Shares, Sentiment, Simple Fact, Slot Machines, Speculative Basis, Stock Market Risk, Syndromes, Tradeoff, Tradeoffs, Volatility
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Bob Janjuah: “Payback for The Rally Coming in Q2″

Friday, January 20th, 2012

Bob “The Bear” Janjuah may appear a little greyer than his previous appearance on Bloomberg TV but his thoughts on the ‘weaker-for-longer’ recovery are as clarifying as ever as he sees Q2 as payback time for the misunderstanding of a mini US business cycle as a real sustainable recovery. Noting that the LTRO does not fix Europe, he sees the worst still ahead for the ‘Eurozone mess’. Discussing expectations for Fed QE3 and moderating growth in Asia/EM, he believes that markets are likely to get ahead of themselves (or have done) even as he recognizes his potential underestimation of the market’s perception of LTRO’s impact on sentiment (pulling forward risk appetite from a QE-driven Q2 rally to the current Q1 ripfest). As we have argued, Bob notes that we are simply not addressing growth or solvency and Q2 will be the payback (looking for a 1000 print in the S&P 500 index by quarter-end) for the policy- and liquidity-driven rally we are undergoing.

Tags: Ahead, Amp, Appearance, Asia, Business Cycle, Current, Driven Rally, Europe, liquidity, Misunderstanding, Payback, Perception, Q2, Qe, Qe3, Risk Appetite, Sentiment, Solvency, Sustainable Recovery
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Every Picture Tells a Story: Market Charts Looking Good (Sonders)

Friday, November 18th, 2011

November 14, 2011

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key points

• With so much focus on the macro, I thought an update on the micro would be welcome.
• Several measures of sentiment, valuation and technical conditions show the market to be in pretty good shape.
• Macro headwinds persist, but the expectations bar has arguably been set low enough to be easily hurdled.

My and my research colleagues’ reports this year have been heavily macro-oriented, for obvious reasons, given massive macro headwinds with which the markets and economy have been contending. However, in my report of two weeks ago, I veered into the future, with a more optimistic assessment of what could go right with the US economy.

Today, I want to look short-term again, but go back to basics with an update on some of the classic fundamentals that typically drive markets. It’s been a while since I wrote about sentiment, valuation, earnings and the market’s technical condition. Since charts often tell the most accurate story, this report is filled with them. I’ll start with sentiment.

But before I get to that …

… we all know it’s been a wild ride so far this year. As I write this, the S&P 500 Index® is flat on the year, having suffered a near-bear market drop of more than 19% from the April 29 high to the October 3 low, and since rallying 15%. It’s no wonder investors are frustrated—last week alone saw a remarkable swing, with the Dow Jones Industrial Average losing nearly 400 points Wednesday but then recovering nearly all of that in the subsequent two trading days.

Sentiment charts

The first sentiment chart below is the well-watched Crowd Sentiment Poll put out by Ned Davis Research. Although optimism did rise along with the recent rally, it remains in the “extreme pessimism” zone—a zone in which the market has historically had nearly 10% annualized returns since 1995.

Sentiment’s Improved But Still Pessimistic

Source: FactSet, Ned Davis Research (NDR), Inc., as of November 8, 2011. Further distribution prohibited without prior permission. Copyright 2011 (c) Ned Davis Research, Inc. All rights reserved.

The next chart is a more direct way to measure investor sentiment and shows the dramatic outflows from stock mutual funds this year versus the inflows into fixed income funds. Over the past five years, individual investors have redeemed more than $400 billion of domestic equity funds while contributing more than $800 billion to (low- or no-yielding) fixed income funds. That swing, of more than $1.2 trillion since early 2007 is, by far, an all-time record change in preference of bonds over stocks, according to Doug Kass, writing for RealMoney.com.

Investor Have Greatly Favored Bonds Over Stocks

Source: FactSet, Investment Company Institute, as of September 30, 2011.

Finally, we can look at hedge-fund sentiment via their net equity exposure, which, as you can see below, is near the low last seen at the market’s March 2009 bottom. Add to that the fact that pension funds’ exposure has been fixed income-skewed and you get a recipe for some reversion to the mean toward stocks.

Hedge Funds Have Not Chased Rally

Source: ISI Group, as of November 9, 2011.

Valuation charts

Most classic valuation measures include earnings in the denominator (the “E” in P/E, or price/earnings, ratio). So let’s start with earnings since we’re well into third-quarter reporting season.

Source: Thomson Reuters, as of November 14, 2011.

With more than 90% of companies having reported, S&P 500 earnings are up nearly 18% year-over-year—well better than what was expected a couple of months ago when recession fears were rampant.

As for valuation on those earnings, to some degree it’s a function of the period one is measuring. One of my preferred longer-term valuation metrics incorporates five-year normalized earnings (four-and-a-half years of historic earnings and two quarters of forecasted earnings). On that basis, the market is trading at 18.2 times earnings versus a median of 17.1 since the late 1940s (the period through which we have data).

Five-Year Normalized P/E a Little Rich

Source: FactSet, The Leuthold Group, as of November 4, 2011.

But let’s look at arguably the most popular valuation metric, which incorporates prospective 12-month earnings. On this basis, the market is dirt cheap at a multiple of 12.4 versus a median of 16.8 since 1990 (the period through which we have data).

Forward P/E Dirt Cheap

Source: FactSet, Standard & Poor’s, as of November 11, 2011. P/Es based on forward 12-month operating earnings.

One final valuation tool I find interesting is to compare the broad environment of today versus the first time the S&P 500 crossed the price at which it’s presently trading.

Source: FactSet, Federal Reserve, Standard & Poor’s, The Leuthold Group. Jan. 6, 1999, represents the first time the S&P 500 hit 1,264 (actual closing price was 1272). Bond yield represented by 10-year US Treasury bond.

Indeed, the S&P 500 has made no headway in nearly 13 years, but the same can’t be said for the economy, valuation (using five-year normalized earnings) or interest rates. The market was overvalued back in 1999, but based on this analysis, it’s quite undervalued today.

Technical charts

Lastly I want to highlight two interesting technical situations I noticed last week thanks to sentimenTrader.com. The first surrounds the Arms Index, also known as the TRIN. It measures the amount of volume in declining stocks versus volume in advancing stocks. A very high number means selling volume is exceptionally lopsided.

Huge Surge in TRIN Shows Lopsided Selling Pressure

Source: FactSet, as of November 11, 2011.

During last Wednesday’s big decline, the TRIN closed above 6. That’s only happened eight times in the past 60 years, and one month later, the S&P 500 was up every time, by an average of 6.0%. Three months later it was up every time except one, by an average of 10.3%, with the one loss a meager -0.1%. What it shows is that we experienced some climactic selling pressure last week, a good sign.

The final technical chart brings in volatility. On Friday, the market experienced the 17th time in the past three months that the S&P 500 SPY (exchange-traded fund trading the S&P 500) gapped by more than +/- 1% at the open and then didn’t close that gap during the day. This means that the S&P didn’t reverse enough to “kiss” the previous day’s close. As you can see in the chart below, this level of “unclosed gap” behavior has been seen only four other times since the early-1990s. All occurred while the market was forming a major bottom.

Source: www.sentimentrader.com, as of November 11, 2011.

In sum …

… this is but a smattering of charts highlighting the present sentiment/valuation/technical condition of the market. Frankly, depending on your bias (bullish or bearish) you could probably find charts to support your case. Even my valuation examples tell multiple stories (no pun intended).

The net for me is I continue to think the expectations bar is set pretty low and that hurdling it won’t be hard. There’s a lot of money on the sidelines as we head into year-end and some of that is under increasing performance pressure. The market isn’t out of the woods, especially as it relates to the eurozone debt crisis, but we think rallies may be more likely than corrections in the near term.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.Examples provided are for illustrative (or “informational”) purposes only and not intended to be reflective of results you can expect to achieve.

Tags: Accurate Story, April 29, Bear Market, Charles Schwab, Chief Investment Strategist, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Good Shape, Headwinds, Impr, Liz Ann, Market Charts, Ned Davis Research, November 14, Optimism, Optimistic Assessment, Pessimism, Research Colleagues, Senior Vice President, Sentiment, Wild Ride
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“Risk-On” is the Flavour of October

Monday, October 31st, 2011

It is fascinating how financial markets moved from risk-off in September to risk-on in October. As shown in the chart below, courtesy of Arthur Hill of StockCharts.com, one can measure investors’ sentiment by comparing the line charts of four ETFs. “The S&P 500 ETF (SPY) and US Oil Fund (USO) rise when risk is ‘on’, while the 20+ year Bond ETF (TLT) and US Dollar Fund (UUP) rise when risk is ‘off’. SPY and USO bottomed and surged as TLT and UUP peaked and plunged,” shows Hill.

Source: Arthur Hill, StockCharts.com, October 28, 2011.

Tags: Amp, Arthur Hill, Dollar Fund, ETF, Financial Markets, Flavour, Hill Source, Investors, Line Charts, risk, Sentiment, Spy, Stockcharts, Stocks, Tlt, Uso, Uup
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