Global retail investor behavior remains a great contrarian indicator

Below is a graph showing the performance of the S&P Developed Broad Market Index (BMI). It represents stocks of some 26 developed markets around the world. Just like the S&P500 in the US - though not to the same extent - the index has had a tremendous rally since the beginning of 2009.

The S&P Developed BMI (source: S&P)

The question is - who really participated in this rally? Te next chart shows exactly what happened.

Source: Barclays Capital (DM = "Developed Markets";
Light Blue = "Retail Investors", Dark Blue = "Institutional Investors")

Until very recently, as institutions were putting money into the market, retail investors were pulling out (keep in mind that globally the situation has been a bit different than in the US). Effectively retail accounts were "suckered" into selling shares to institutions at low prices. Early in 2013, retail investors stopped pulling money out and in the summer, just when equity prices hit new highs, they started putting some money in. That is why retail investor behavior remains a great contrarian indicator.

SoberLook.com

From our sponsor:

US equities and the "Rule of 20"

Jim Moltz

Numerous analysts - often the same ones that were bearish just six months ago - continue to talk up US equities using a variety of metrics. These include comparisons of dividend yields or PE ratios to treasuries, etc. One of the more unusual metrics is the so-called Rule of 20. Developed over 30 years ago by Jim Moltz, the rule states that for equities to be "fairly" valued , the average PE ratio plus the inflation rate has to be around 20. With the current PE ratios, the Rule of 20 metric now clocks at around 17 (PE=15, Inflation =2). That means to be valued "fairly" on a historical basis, US stocks' PE ratio should be around 18, allowing quite a bit of room for multiple expansion. That's assuming of course that inflation stays subdued. Also Mr. Moltz likely didn't contemplate deflation risk when designing this rule.

Historically the Rule of 20 performed well in 2000 by pointing how overvalued the market was prior to the correction, and then again in 2007.

Source: The ISI Group

According to ISI, the current situation is more akin to 1983, when we were still living in the shadow of the "Death of Equities" and the Rule of 20 metric was at the lows. This "death" was proclaimed in 1979 on the cover of Business Week, which read "How inflation is destroying the stock market". Of course by 1983, after Volcker had raised the Fed Funds rate to 20% in 1981 (hard to believe, right?), inflation rate had receded. The "anti-equities" mentality however still persisted, creating an opportunity. Since then, the S&P500 increased more than 10-fold (particularly if dividends are taken into account). The Rule of 20 therefore paints an incredibly bullish picture for the US stock market over the next couple of decades. Will Mr. Moltz be proven right again?

BW from 1979

SoberLook.com

From our sponsor:

5 reasons to remain cautious on U.S. equities

US equity markets are touching multi-year highs as investors increasingly allocate to the risk-on trade. But there are a few signals that may indicate some need for caution - at least in the short-term:

1. As discussed earlier (see post), consumer sentiment remains quite weak, which could easily create headwinds for corporate earnings.

2. Energy prices have been on the rise, with WTI crude oil at the highest level since September.

3. Regional manufacturing data isn't showing much improvement. The Richmond Fed index came in significantly below expectations.

Richmond Fed Manufacturing Activity Index

What's particularly troubling about this index is that the component tracking manufacturing output prices declined while input prices rose. Not great for margins.

Richmond Fed Manufacturing Activity Index

The Philadelphia Fed Survey and The Empire State Mfg Survey also both came in materially below expectations last week.

4. At the national level, activity remains subdued. The Chicago Fed National Activity Index today came in below analysts' forecasts. U.S. economic growth is still fairly weak.

Source: Econoday

5. From a technical perspective, the world all of a sudden turned bullish. According to Merrill Lynch, investor "cash allocations fell to the lowest level since February 2011" and "allocation to bonds fell to lowest level since May 2011". We may not yet be at a level professionals would view as a contrarian signal, but this should certainly signal a need for caution.

SoberLook.com

From our sponsor:

The stock market likes government gridlock

The probability of another four years of gridlock in Washington is rising as shown by the combined odds of Obama's reelection and the House controlled by Republicans.

Source: JPMorgan

Many investors of course complain about how bad this is for the financial markets. But is this outcome really bad for the stock market? The S&P500 is up 15.75% YTD (including dividends) - is that an indication of a market concerned about an impasse in DC? The reality is the market may be liking this more than people realize. It is possible that much of the fiscal cliff will be kicked down the road, and no major changes in government spending will actually take place. Again people will say this is a horrible outcome. But if you are a blue chip US company, is it really that bad?

GE, Pratt & Whitney, Boeing, United Technologies, Lockheed Martin, General Dynamics, Raytheon, IBM, Oshkosh, McKesson, BAE Systems, L-3 Communications, SAIC Inc., just to name a few, are some for the large firms that count the Federal government as a top customer and benefit from the status quo in Washington. Fedex is in the middle of it, loving all the government shipping. Pharmaceuticals and suppliers like McKesson and Cardinal Health count on the government for massive contracts to supply the military as well as making money on all the Medicaid/Medicare fun. Accountants like Deloitte do tons of "bean counting" for the Federal government and ring the register. AT&T "reaches out and touches" many government employees.

Of course Microsoft provides software for most government PCs (while Dell supplies the hardware). But so does Google these days with Google Apps, Google Docs, Calendar and Sites, as it benefits from more government spending. And if you think Apple just sells to the private sector, think again - here is different kind of Apple Store.

Wall Street likes to talk about the evils of government spending, but beneath it all portfolio managers (when they actually think about where their portfolio companies make money) and of course a number of company executives want their big client Uncle Sam to keep on spending. Eventually it will be time to pay the piper, but for now life is good with the US government in status quo mode...

SoberLook.com

Q2 earnings surprises masked weaker revenues

Analysts have been pointing out that earnings for the S&P500 companies continued to surprise to the upside for Q2 results. The top-line numbers however were not nearly as impressive. In fact this has been the lowest percentage of positive revenue surprises since at least 3Q09.

Nasdaq: - While roughly two-thirds of companies beat earnings expectations, the beat ratio on the revenue front is far weaker - only 37.6% of the companies have beat revenue expectations. Even some of these companies with positive revenue surprises for the second quarter have guided towards lower revenue numbers in the coming quarters. This does not bode well for growth in the coming quarters.

Source: Barclays Capital

The global macro pressures have impacted revenues far more because of a sharp decline in commodity prices that helped improve margins.

Barclays Capital: - The global growth slowdown has had more of an impact on revenues, as margins were aided by a sharp drop in commodity prices in the second quarter. Additionally, ... companies have begun to cut their forward financial outlooks, suggesting that macro concerns are beginning to weigh on corporate operating performance.

Given the recent reversal in commodity price declines, the ongoing macro concerns, and lower revenue guidance in the coming quarters, the Q3 earnings picture now looks far less certain. The strong market performance in recent weeks however seems to be ignoring this development.

SoberLook.com

Based on history, corporate credit should be outperforming equities

As discussed in this post, US equities have outperformed (albeit at much higher volatility) US corporate credit this year - both HY and IG.

S&P500 vs HY and IG liquid indices YTD total return (click to enlarge)

But is this outperformance consistent with the current economic environment in the US? Here is how the asset classes have performed during different ranges of GDP growth from 1980 to today .

Source: DB ("SPX TR" means S&P500 total return - including dividends)

Since we are likely to be in the middle bucket for 2012, credit should be outperforming equities. If we make this comparison using non-farm payrolls monthly changes, we get a similar result.

Source: DB (click to enlarge)

Either we are going to be returning to the first quarter type job growth in the US later this year (which seems unlikely) or equities look expensive relative to credit.

Non-farm payrolls monthly

SoberLook.com

Crude oil vs US equities - a dislocation?

Business Insider (Tobias Levkovich): - ... the equity market has been linked quite tight with oil prices over the past five years, thereby making the recent divergence a bit more interesting. We suspect that some of the difference may be coming from the new developments in the US energy industry tied to technologies allowing for more deepwater drilling, horizontal drilling, shale gas and tight oil...

When running a regression of the absolute levels over the past 3 years, one would obtain an R-squared of 0.8 (correlation of 0.9) between the WTI futures and the S&P500. Clearly both are highly correlated to the US economy and the energy sector is a sizable component of the US equity market (about 13% of the S&P500). That is why this recent divergence between the two asset classes really stands out (chart below).

WTI vs S&P500 (3 years, daily) - red asterisk is the current level

Levkovich may be right about the changes taking place in the US energy industry. Declining global demand can also explain the divergence between the two. WTI rising supply is clearly another factor. But these types of changes are generally far more gradual than this sharp dislocation we've experienced recently. One could therefore argue from this chart that either the US equities are overvalued or WTI has sold off way too sharply in recent weeks .

SoberLook.com

Equity prices vs. inflation expectations

In recent years we've seen a clear indication that inflation expectations and US equity prices are correlated. Certainly once inflation reaches a certain level (by some estimates 4%), the relationship will break down and even reverse. However in the current environment deflationary risks drive this relationship. In other words we have an aggregate demand problem rather than any supply constraints. Expectations of price increases are a sign of a potentially stronger demand growth and higher margins, which is a positive for shares. The scatter plot below shows the relationship between the US equity prices and TIPS-implied (2x2 breakeven) inflation expectations over the past 3 years. The correlation has been surprisingly stable (around 0.86).

R^2 = 0.74

The current level however seems somewhat out of place, at least based on recent history. It shows that either inflation expectations have declined too sharply (now at 0.82%) or US equities are still overpriced.

SoberLook.com

The decade of equity underperformance - even against the housing market

Here is a sad statement on the "lost decade" of the US equity market. The S&P/Case-Shiller Composite-20 Home Price Index, the most commonly used indicator of the US residential housing market, was launched on January of 2000. Since then the housing market has outperformed the S&P500 (although the gap has narrowed considerably recently). The comparison below only includes price appreciation for the housing market. A better comparison of relative performance would be to treat the housing market as an investment property, adding rental income to the price index returns. Such an adjustment would show an even greater underperformance by the equity market.

SoberLook.com

Cyclicals' persistent underperformance

Cyclical shares started underperforming the broader market in August of last year. What's interesting is that on a relative basis they never recovered.

QE2 driven demand for natural resources and rapid growth in emerging markets kept cyclicals at lofty valuations. When growth expectations moderated in August (after the end of QE2 and with the spike in Eurozone related fears), cyclicals underperformed materially.

In spite of the recent market rally however, cyclicals-to-broader-market gap continues to persist - about a 12% total return gap from 12/31/10. The market is no longer putting as high of a valuation on these shares because expectations of global growth continue to be subdued (in spite of improving economic signals in the US). That may indicate that the broader market rally may be capped by these reduced growth expectations.

Morgan Stanley Cyclicals Index vs. the SP500 total return (Bloomberg)

SoberLook.com

The dollar - equities correlation reversal

The dollar's status as a "safe haven" currency (see this post for some background) came into question yesterday. Typically in a "risk on" equity rally, we've seen the dollar sell off. The reverse was also true as the dollar tended to rally in a "risk off" scenario (particularly when the world looked scary). "Safe haven" currencies tend to be negatively correlated with risk assets such as equities. But yesterday we saw both the equity markets and the dollar rally.

The US Dollar (DXY) vs. the Dow - daily moves for the past 12 months (Bloomberg)

This change in correlation from negative to positive may indicate the market's perception of US rates moving higher sooner than expected (which would make the dollar more attractive on a relative basis.) The Fed Funds Futures curve has shifted the expectations of the first Fed rate hike to June of next year (from August). These changed expectations should bode well for the dollar going forward, and days of the correlation reversal may become a more common occurrence.

Shift in Fed Funds Futures implied rate (Bloomberg)

SoberLook.com

Treasury yields and credit spreads divergence is not sustainable

There is a great deal of discussion in the market about the dislocation between US equities and treasuries. It is somewhat surprising that people are only now starting to focus on the issue - the divergence has been visible for quite some time and was discussed here.

But another divergence which is quite striking exists now between corporate bond spreads and treasury yields. The chart below compares the investment grade CDX (index CDS) with the 10-year treasury yields.

The treasury market continues to trade with a built in "Europe risk premium". Some managers hold treasuries as a hedge against European surprises - a strategy that has worked quite well recently (as opposed to equity index puts). But this divergence is not sustainable in the long term and treasury yields should start rising later this year.

SoberLook.com

Technical indicators point to need for caution

Investors Intelligence is reporting the highest reading of bullish oriented news writers since May of 2011. Those writing articles with a bullish sentiment now make up 52%, while bearish views are down slightly from prior week at 29%. Many who have been predicting a correction have become bullish, with those in the "corrections camp" now at 19%, the lowest in 4 weeks.

With VIX at July-2011 levels and the CS Risk Appetite Index clearly in the neutral zone, this may be time to become more cautious on the equity markets. While fundamentals remain strong, one needs to watch the technicals more closely. 

CS Risk Appetite Index (source: CS)

SoberLook.com

Persistent resilience of the US equity market

The US equity market continues to stay resilient after beating every major equity market globally in 2011. This is upsetting many investors, as numerous fund managers and individuals are underinvested or short. We are still getting angry emails about the October 15th post called "It's green light for the US equity market - for now". In spite of all the dire predictions however, the S&P500 is up nearly 6.5% since that post.

S&P500 performance since Oct 15th

Going forward we may in fact see some pullback given this quick rally.  We may also have some headwinds from the US budget issues and an uncertain employment picture.  Europe will continue to weigh on this market even if the US stages a partial decoupling from the eurozone issues.

Longer term the US equity picture remains benign.  With the S&P500 dividend yield above the 10-year treasury rate and PE ratios of around 12, the market is not overextended.

SoberLook.com

The S&P500 outperformed all major stock markets

The US equity market outperformed every major equity market globally in 2011. It is also the only major market with a positive return for the year. Below are the total returns shown in local currency.

Total Returns for 2011

SoberLook.com

Will Obama be reelected? Just watch the stock market

President Obama's 2012 Intrade reelection odds now stand at about 52%, roughly a 2% increase in the last few days. What has changed to make the "crowds" assign a higher probability to this event? The payroll tax situation remains unsolved, the deficit issue still looms large, and the Republican candidates still have the same issues they had a week ago. The one thing that did change however is that we've had a stock market rally. Is there a relationship?

The charts below show that day-to-day the relationship may not be strong, but the similarity in trends is unmistakable. This is a six-month chart that takes us through the worst of the crisis (the Intrade contract wasn't very actively traded prior to that).  The two track well during earlier period as well, except when Osama bin Laden was killed, the President's reelection chances spiked for a short time.  The market went up too, but not nearly as much.

The top chart is the Intrade probability of Obama becoming president for the second term, while the bottom chart shows the S&P500 index.

Obama reelection probability vs. the S&P500

This is by no means a proof of causality, but the relationship may indicate that whatever factors drive the equity markets may be the same factors that benefit an incumbent president.  Once again we may have an indication that politics and the economy are even more inseparable than we imagined.  

SoberLook.com

Equities and swap spreads - misbehaving again

The saga of diverging risk indicators continues. Today the contradiction could be observed intraday. The equity market rally was fairly sustained.

S&P500 Futures (Bloomberg)

As expected, credit spreads tightened.

Investment Grade CDX

...yet the rally in stocks was coincident with a sharp widening in swap spreads.

USD 2-year Swap Spread

Typically equity prices and swap spreads move in the opposite direction, with a correlation coefficient of around -0.4.  Swap spreads are market expectations of future LIBOR spreads to treasuries.  When LIBOR is expected to stay elevated relative to treasury yields, it points to uncertainty in interbank funding - an indication of risk. At 49 bp USD 2-year swap spreads continue to be elevated relative to the post-2008 history.  One possible explanation would be that as equities rally, traders are protecting the downside by going long swap spreads (given that equity puts have not been as effective).  Swap spreads are sometimes viewed as cheap "tail risk" protection and the current uncertainty dictates that some protection is quite necessary.

SoberLook.com

It's green light for the US equity market - for now

The US equity market is poised for a near-term rally. It is a difficult statement to make, given all the headwinds, but the signs are there.

Let's start by looking at US based factors that should impact the S&P500.

1. The US economic data coming in has been quite decent. The initial jobless claims are at the lows.  We all know the issue with the US unemployment figures, but the trend is unmistakable.

Initial Jobless Claims (Bloomberg)

2. US equity valuations look attractive on a historical basis.  The next chart shows the S&P500 P/E ratios, both trailing and projected plotted over time.  The last time we were at these levels was in early 2009.

PE ratios (Bloomberg)

3. Interest rates, and in particular the mortgage rates are at historical lows.  The 30-year fixed conforming mortgage rate is now below 4%.  This will generate some refinancing for those who are able, adding some disposable cash to the system.

Source: BankRate.com

4. Commodity prices, particularly food and energy have come off sharply.  Corn, wheat, cotton are near recent lows. This should be a positive for both the US consumers and many corporations.  Having access to abundant cheap domestic natural gas should be helpful as well.  The chart below shows the CRB commodity index.

CRB Commodity Index (Bloomberg)

5. A technical concern weighing on the markets has been the issue of option expiration. This Friday (12/16) is the largest option expiration of the year with about $950 billion worth of S&P500 options (on futures and ETFs). Investors are uneasy about large short gamma positions distorting the market. This overhang will be out of the way next week.

Source: Goldman Sachs

Now let's consider the developments in Europe that have been holding down US equity valuations.

6. Europe has gotten serious about their fiscal integration plan. France and Germany are driving the process and the eurozone is on board - at least for now.

7. We had two critical auctions - one for Italian bonds and one for Spanish bonds. The yields are high, but these nations were able to sell all the debt they planned and as far as we know the debt was sold to private investors. That gives the eurozone hope that these countries can in fact roll their debt without the EFSF, the ECB, or the IMF - at least in the near-term.

8. The upcoming sovereign downgrades by the S&P have been clearly telegraphed to the markets.  And now with the auctions out of the way, the ratings may actually come in better than expected given the results.

9. Central banks have shown a willingness to provide unprecedented support to financial institutions.

Clearly tremendous risks remain and we may yet revisit the "dark days" of September. But in the near term the overall picture looks positive and the S&P500 has a "green light" to rally.

SoberLook.com

Bulls vs. bears - a contrarian indicator?

Individual investor has turned bullish on the equity markets, but only modestly so. The chart below from Credit Suisse/AAII shows the relative difference between individuals who are bulls vs. those who are bears.



There is a general perception out there that one should be positioned as a contrarian to individual investors. However if you look at the chart of the S&P500 over the same period, it's not clear if the retail guys always get it wrong. Certainly a bullish view in 2004 would have worked.



But many argue that the overwhelmingly bearish views this year had kept the equity markets strong, and any sign of strong bullishness from the retail investor going forward is a signal to get out.

On the way to euphoria

As the US equity market rally continues, many point out that the S&P500 is still 21% below last year's level. We still have ways to go just to get to last year's levels. Stocks are still cheap. Right.

The chart below shows the S&P500 level as well as the PE ratio, both the trailing ratio and the estimated PE (based on Bloomberg survey). Both PE ratios are at multi-year highs. The projected PE number of nearly 17 times earnings is particularly troubling because it's a forward looking measure. These levels indicate that equities are really expensive.



So why are people buying stocks with such enthusiasm? A few possible reasons here:
1. analysts are completely underestimating next year's projected earnings,
2. earnings growth in the next few years will significantly exceed historical growth,
3. stock market euphoria is back.

According to Credit Suisse, number 3 is more likely, or at least on the way there. The following chart shows the levels of risk appetite in the system, and we may be on our way from "panic" to "euphoria" in a matter of a few months.



Euphoria has been known to carry asset levels way beyond fundamental valuation, and that's exactly what may be happening here.