Last time we looked at this chart (1st June here), equities were about to dip lower. Now with the European mess behind us, equities have all but recovered that lost ground. It’s just that this has been achieved with fewer and fewer stocks pushing higher relative to their more pessimistic siblings. Declining market breadth suggests a lack of conviction in the most recent recovery.

So will the inevitable resolution of the US debt ceiling debates clear the way for broader participation – and maybe even new highs in the S&P500 index? Perhaps – though maybe the markets have overestimated the ability for politicians to amicably resolve the issue. In any event, without a meaningful break higher in market breadth, we’ll be waiting for the return of the government stimulus machine before adding meaningfully to long positions.

Okay, it’s no Swan Lake – but following on from our earlier note (here), it is uncanny how market breadth continues its graceful exit stage right. If the augers are keeping it real, then the current market weakness has a little further to run.

From the market low in 1884, the market added around 5% per annum – the blue line above illustrates what straight line growth of 5.2% per annum would have looked like. (For clarity, this does not include dividends.)

A couple observations from this chart:

1) The relative step up in the market from the mid-70′s onwards neatly coincides with increasing leverage in the Australian economy. With the baby boomers reaching asset liquidation age, it’s reasonable to suppose that we are approaching the more difficult part of the market valuation cycle.

2) It takes a long time to work off excesses (see an earlier article here), whether by inflation, saving or innovation – something like 13 – 15 years seems about the norm. On the assumption that we are in a bear market cycle, that started in 2007, we might expect the market then to regain its recent peak around 2020. Still, one could argue that this is view of the world is redundant if we have simply become a vassal of China.

Zooming in a little to look at how the market performed over a number of cycles, the following chart starts from the market peak in 1970. (Note that the blue trend line in the chart is the exact same one that we saw in the earlier chart – that 5.2% per annum growth since 1884.):

On the assumption that this ~5% growth in the market is the mean that we keep reverting to, then this chart seems to confirm that fair value might see the market back at its 2007 peak around 2020.

Perhaps its not so remarkable that the Australian market appears to have a speed limiter set at around 5% per annum.  That roughly equates to our long term growth in GDP amplified by corporate leverage on earnings.

And as if to further reinforce the point, the following chart maps the growth rate peak to peak and then low to low between 1987 and 2007. Once again it seems that the an annual growth rate of around 5% seems about right for the Australian market.  The yellow trend line in the middle takes the mid-point of the 1987 high to low and extrapolates growth forward at our magic 5.2%.

Think these trend lines pretty neatly capture reasonable expectations for the range for the market that we can expect for the next few years. With peak debt likely behind us, think we can expect the squiggles to be contained between 3000 and 5500 for a year or five yet.

So while the fundamentals continue to eat away at the current valuations, the market pushes tenaciously onwards. It’s curious but as I flick through various industry group charts, there appears to be funds flow supporting property, financials and even consumer discretionary.  The only sector that really stands out as being on the nose is resources (ex-energy).

The chart of the All Ordinaries brings this fully into relief:

At face value, this is a chart of a price that is ready to break higher. The Money Flow Index (MFI at the bottom of the chart) which blends volume with price illustrates the point that money has been sucked into this latest test higher. The only real sign that the internals are weak is being given Momentum (MTM) that continues to make lower highs at each flourish of the index higher.

So what to make of it all?

We have some pretty important levels converging at present. A break of either would generally signal near term direction in the market.  For example, a definitive break of 5000 could well trigger a sharp move towards 5400/5500. Alternatively, a break below January’s low of 4800 would take us through the uptrend that has reigned supreme since March 2009, and set up a key reversal.

Perhaps the Middle East conflagration is enough to topple the Fed’s bid.  Or equally, the signs are that authorities are having a hard time reigning in growth in China – expectations are for a seasonal bounce back in their PMI in March, something that their equities market and the baltic dry index would seem to be suggesting. Arguments can be made for both the bid and the offer. It is often just as sensible to hedge your bets – well at least that is what I’m looking at.

Conclusion

There is some logic to investing some cash in your favourite property and utility stocks in the current market. I’m yet to make the leap, but the sectors have well and truly lagged the broader market and while risk spreads may have some room to widen, these stocks will also benefit from a flattening of the yield curve should the economy turn definitively south.  As for financials, I find it really hard to stomach the thought of owning banks with all the headwinds that they are facing.  Rather, my preference is for life insurance that should hedge against broader market strength while offering stock specific upside from banking industry weakness.

Consider the following chart of the NYSE McClellan Summation Index.

For the uninitiated, the summation index is a measure of market breadth. It looks at the number of stocks going up as against the number of stocks going down and, to put that figure in context, looks at how the net result is moving over time. As such, it is a reasonable indicator of how capital flows are being distributed through the market. (For a fuller explanation, refer to McClellan publications here.)

So to the chart above, the summation index has been struggling to regain even its late 2010 highs and in doing so has been defining a bearish divergence as the NYSE index has been stretching to new heights. This suggests that the market has been gaining ground on the backs of fewer and fewer stocks.  We could interpret this as more and more stocks are bumping up against valuation constraints – or put another way, valuation multiples can only move so far ahead of earnings growth.

Even with $50bn in POMO purchases scheduled into the end of January, a few days of heavier volume selling could well tip the summation index back towards bearish territory. We’ll see how it behaves assuming the selloff continues – being alert to any positive divergence (ie. lower NYSE index with the summation index turning higher) as a sign that buying has kicked in. Bigger picture though this indicator is suggesting that the internals of this market aren’t all that healthy.

The concept seemed a good one – worthy of further investigation.

However, rather than asking how the VIX responds to changes in the S&P500, we turned it around and asked how does the VIX anticipate changes in the S&P500. Perhaps it’s the same question – as who knows which leads which. In any event, it seemed easier to understand a model that mapped the S&P500 as implied by movements in the VIX.

So following are the charts of the actual S&P500 and that implied by movements in the VIX starting from 1Oct09:

Our results are broadly similar.  Three key divergences between the VIX derived S&P500 and the actual price were identified that did indeed precede changes in price direction. At price extremes, there arose a disconnect between the behaviour of option traders and the broader equity market.

Most unhelpfully, the seeming catalyst for McClennan’s article – that we may currently be witnessing another divergence developing was not really confirmed. Though it’d be fair to conclude that the derived S&P500 chart has all the hallmarks of a market undergoing a topping process. We’ll watch this indicator with interest to see how things develop from here.

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Epilogue:

Note that correlation changes over time and, not unsurprisingly, falls the longer the period under consideration.  So that the correlation is ~74% for the period 2004 to today, rising to 79% from Jan08, and is 85% for the last year. As with most time series analysis, the start date will have an impact on results.

In backtesting though the analysis retained its value. For example, there was a significant divergence between the VIX derived S&P500 and the actual S&P500 index around the March 2009 lows. The longer term data set is as follows- note the relative performance through 2007:

So herewith is the log chart of the All Ordinaries price history since 1875:

Now you might argue about the choice of market cycles – I admit to liking the symmetry of ~27 year bull markets against ~13 year bear cycles.  But the point remains that with 2007 ushering in the end of the global debt party it looks likely that we’ll be trading in the bear zone for some years to come.

]]> http://www.datadiary.com.au/2010/08/17/australian-equities-in-the-bear-zone/feed/ 1 http://www.datadiary.com.au/2010/06/03/sp500-by-sectors-financials-and-consumer-discretionary-outperform/ http://www.datadiary.com.au/2010/06/03/sp500-by-sectors-financials-and-consumer-discretionary-outperform/#comments Thu, 03 Jun 2010 02:01:00 +0000 Rohan Clarke http://www.datadiary.com.au/?p=2713 It’s interesting that financials and consumer discretionary – the sectors that were most richly rewarded with government support through the crisis – are outperforming the broader index.  Still with the financials about to cycle back to the 1950′s (cardigans and crewcuts) and the credit revaluation trade a receding hairline, it’s hard to see this outperformance prevailing.

But then looking to the energy and materials sectors, it’s also hard to get enthusiastic about their prospects either.  With both currently trading through their 200 day MA, it’s likely a matter of time before the dreaded death cross (50 day MA trades through 200 day MA) is stamped on their foreheads.

While in the boiler room of the economy, the homebuilders subindex has also dropped through its 200 day MA.  If a healthy home construction sector is the bedrock of an economy, then this chart is displaying disturbing symptoms. It’s a volatile beast, but with the builders trading below the broader index – it’s a fair chance that the macro economy will follow.

Finally, and perhaps the cleanest to interpret of all, the capital intensive sectors are capitulating.  The realisation that credit spreads will be driven wider by the global scramble for capital is slowly permeating the equities (and debt) markets.  It’s remarkable that the financials remain seemingly immune to this trend…

The evidence that it’s a ‘this time it’s different’ correction?

1) Uptrend since March 2009 has been broken – Uptrends in all the major indexes have been decisively taken out. With China’s stockmarkets trading below their 200 day MA, the question is whether global markets will follow.  (see Humble Student of the Markets here)

2) Investor bullishness was at extremes – as measured by sentiment indicators from newsletters to the CBOE PutCall ratio.  A rapid switch of the greed to fear button will have longs questioning what is fair value for equities. (See DataDiary summary from 19 April here)

3) The momentum of the recovery has slowed with fading stimulus –  A lesson from the Japanese 1990′s experience was that the market goes up with government stimulus and down when the stimulus is removed. This patient needs more blood.  (see Albert Edwards Global Strategy Weekly here)

4) Fat tail political risk is in the house – Before the GFC was invented, the rules of the game were that credit risk could be sliced and diced into infinitely smaller pieces.  We assumed that legal and political risks were immaterial. They aren’t.  The immediate question is how to price ‘unhedgeable’ political risk – the unravelling of Europe, the bankruptcy of US states and even Australia’s new commodity taxes.  It’s telling that gold continues to squeeze higher – there’s precious few places to hide (see STRATFOR article “The Global Crisis of Legitimacy here).

Conclusion

This isn’t a clarion call to abandon ship.  It isn’t 2008 – with margined investors having their stock dumped into the market.  Sure there may be a carry trade or three that needs to be unwound, but buying on margin has not regained its 2007 highs.  For this reason, will be looking to add some long exposure at my estimation of fair value (see articles here and here).

In order for the markets to retest the March 2009 lows, something else needs to happen – like China imploding in a fug of property and commodity speculation.  This is a material risk – certainly the leverage in the commodities markets that has been fuelled by the rise of financial players (read article by Absolute Return Partners here) has as its single biggest assumption the ‘China industrialisation story’.  In a real sense, Australian house price euphoria is an extension of this same trade.

Volume peaks tend to be associated with short to medium bottoms in the index.  Similarly, troughs in volume often signal some kind of top.  Or course this relationship doesn’t always hold – a wicked example being that 2008 price avalanche where volume peaked around 8bn shares per day and then thrashed around below that level until the March 2008 floor was eventually reached.

Still is there some significance to the recent rise in activity?  Some thoughts for your consideration…

1) It’s a ‘reversion to mean’ volume – While it’s incredible (and clearly unsustainable) that volume increased over 20% per annum since the beginning of 2004, the question remains what is the underlying trend in daily volume.  On a trend basis we may still be south of that level.

2) Buy the dip – the risk compression trade is alive and well and about to enter it’s next phase.  This would have more credibility in my book if risk appetite had also blown out already.  It hasn’t.

Credit spreads in Europe may have dissolved in a gelatinous mess, but the US credit markets remain blase about this state of affairs.  Similarly, the VIX has sprung to life but not nearly enough to signal that we are in a renewed bout of risk aversion. The relative calm can be seen a little more clearly via our risk appetite index:

As an indicator, we would normally expect the index to have dipped towards -2% before the ‘panic’ volume spike was upon us.

3) Risk aversion is on the rise  - My best guess is that the rising volume is part of a change in trend – that’s it’s more likely to represent distribution than accumulation.  Witness the Merrill Lynch hedge fund position report (via Market Folly) suggesting that funds have been reducing their equity exposure. If this is the case, then it’s likely that there are a few even higher volume days in the wings.