The first half of 3Q is done. So far, it’s been a mess for equities worldwide. Europe and RUT are down 5-6% and SPX and DJIA are negative. Only Nasdaq and emerging markets show gains.
In the US, only technology and health care have advanced; all the other sectors are in the red.
Surely the biggest surprise has been treasuries. After outperforming SPX by 680 bp in the first half of the year, treasuries (using TLT) have taken another 600 bp in just the past 6 weeks (purple bar, above).
You would guess that the fall in rates, which is flattening yield curves, would be a negative for US equities, indicating slowing growth prospects. However, the historical record is ambiguous.
In the chart below, times when the curve flattened and stocks rose are shaded green; when stocks fell, it is shaded red. Throughout most of the prior bull market, the yield curve also flattened, yet stocks rose. In the current bull market, the pattern has mostly reversed. The current period is an exception. A repeat of the 2004-06 paradigm is not improbable and may already be underway.
Our monthly macro update (here) has made clear that the balance of data in the US points to positive, but tepid, growth on the order of 2% real per annum. This is unspectacular growth by historical standards, but its modestly inflationary. So what’s driving yields lower?
The answer must be competing yields, especially in Europe. German bonds, like those in Japan, now yield less than 1%. In comparison, US 10 year yields of 2.35% are attractive (the next two charts from Cullen Roche).
So long as US growth is sustained, and provided, importantly, that Europe does not contract, yields might well remain low while US equities advance. This week’s industrial production figures, with growth of 5.3% yoy (manufacturing only), was the best in 3 1/2 years. The watch out, again, is Europe, whose growth (and inflation) is barely positive.
Further impetus to falling yields may well come from fund managers. Fund managers surveyed this month by BAML are a net -62% underweight bonds in their portfolios. Despite falling equity prices relative to bonds, their allocation to bonds has not increased.
Even more remarkably, their expectations are that short term rates will increase in the coming months. 78% hold this view, the highest since May 2011, after which 5-year rates dropped from 2% to 0.5% in the next year. Managers have a very bad track record in predicting short term rates; they have been wrong 8 of the last 9 times they were this confident rates would increase (the next three charts are from BAML).
Overall, fund managers remain overweight equities. Recall, in July, managers had their second highest overweight position in equities in the past 13 years, a clearly identified risk to near term equity performance (post). Since then, equities worldwide have fallen 5-8%.
In response, equity allocations have fallen to +44% overweight. Is this a washout? No. In the past, after overexposure like that seen in the past 18 months (yellow), a washout low would be marked by an equity weighting under +20% (green circles). By that measure, equities are still highly over owned.
But the current bull market is nothing if not persistent. Equities have not been less than +36% overweight since early 2013. If this is buy support again, then weakness in August will likely mark a low in the next month like those in February and April.
The other factor in equity bulls favor is that cash levels rose above 5% in August. The number instances is low but cash above 5% has been close to lows in 2002, 2003 and 2012. It was a bit early in 2011 and very early in 2008-09. But overall, this is a positive and would likely be more so with further equity weakness in August.
Read more on fund managers’ current asset allocation here.
The Week Ahead
Before looking at the indices, a word about the trading pattern this week. It smelled like distribution. SPY moved up $2.5 of which a net $2.4 (96%) came as a result of overnight gaps. Cash hours were on low volume (except Friday) and 3 of the 5 days moved lower from open to close. So prices moved up, making the charts look fine, but its the kind of trading that can precede weakness. Why? Because there was no follow through when most market participants were at their desks. We noted the exact same pattern at the end of March before the April swoon.
Nasdaq is back at a fresh 14 year high. But only 40% of its constituent stocks are even above their 50-dma or 200-dma. The rally did not carry many stocks higher, at least not yet.
We should also note that whatever positive seasonality August offers is now mostly behind us. This week and the next become increasingly soft. That would fit the 6th year of the presidential cycle pattern as well (chart from Sentimentrader).
NDX remains the strongest index. In our last weekly update (here), NDX had found support on its 50-dma. There was no foul. In the ensuing two weeks, it has moved to its highest close in 14 years. Its high RSI, near 80, is normal after being oversold. NDX is perfectly healthy, but if it should quickly return to its 50-dma, it will likely break support and trade down to its February-May trading zone (yellow shading).
SPY just about tested its February-May trading zone at the recent low. It held, as expected, and today it closed back above its 50-dma. There are two positives.
First, SPY has both a positive MACD cross and it’s 13-ema is rising. That’s been a set up for higher prices in the past (blue lines). That’s not to say that it won’t pause at its 50-dma or retest that 50-dma in the near future, but the pattern has been for the recent low to hold.
Importantly, when that set up has failed, it has been right at the 50-dma (arrows), so next week will be key. Usually, the 50-dma has sloped downward when the set up has failed in the past; at present, SPY’s 50-dma is rising.
The second positive is that, should SPY hold its 50-dma, it has recently advanced quickly higher. Shown in yellow below are prior times when SPY has moved back above its 50-dma in the past year; this has been when long win-streaks have occurred as traders adjust their positions.
On Friday, SPY met resistance (at 196.5) formed by the June highs, the July lows and the former trend line from February. The violent move down tested support at 194. While the drama was unexpected, it did not produce a foul. Next resistance after 196.5 is 198. That is our current expectation. A close below 194 sets up a move back to the recent lows near 191 and, quite likely, a fuller retest of the February-May trading zone top near 189 (shaded to the left).
The watch out for weakness is RUT. It continues to lag SPX and NDX. It closed Friday below its 200-dma and, more importantly, below the key 1160 resistance level. Watch the 13-ema (lower panel); should that inflect downward next week, it would be a set up like mid-May and augur a larger breakdown. This is a good canary.
Lastly, as mentioned earlier, treasuries continue to be the stars of 2014. The trend is higher. But price moved well above its upper Bollinger on Friday; in the past, this has been a set up for a retrace before moving higher (blue line and shading).
Our weekly summary table follows:
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