Gold And Oil: Have The Charts Been Helpful? article and charts here.
Strongest Six Months In A Decade
It is difficult to imagine a new bear market starting when the economy is growing and the technicals are favorable. Tuesday’s GDP report showed the U.S. economy is coming off the strongest six months of growth in a decade. From Bloomberg:
Gross domestic product, the value of all goods and services produced, rose at a 3.9 percent annualized rate, up from an initial estimate of 3.5 percent, Commerce Department figures showed today in Washington. The median forecast of 81 economists surveyed by Bloomberg called for a 3.3 percent gain. After the 4.6 percent increase in the second quarter, it marked the biggest back-to-back advance since late 2003.
The Weight Of The Evidence
Outside of GDP, how does the bigger picture look? Things have happened fast over the past four weeks. This week’s stock market video takes a step back and looks at the new evidence that has surfaced in the stock market since the October 15 low.
Given the still constructive environment for growth assets, we recently reduced exposure to bonds (IEF) and added (once again) to our equity stake (SPY). Even the strongest rallies experience red days from time-to-time, meaning we have to have realistic expectations in the short-run. However, it is possible the market is just digesting gains and ready for another push higher.
As always, the market and data will guide us if we are willing to wake up each day with a flexible, unbiased, and open mind.
Things have happened fast over the past four weeks. Video takes a step back and looks at the new evidence that has surfaced in the stock market since the October 15 low.
Yesterday, we covered an analysis about a potentially bullish signal in market breadth. A common form of feedback was:
What about the divergence between market breadth and the S&P 500…doesn’t that look like October 2007?
The present day divergence is explained in the chart below.
A Showstopper For Bulls?
In this article, we are attempting to answer a simple question:
Is it possible for a bull market to continue after this divergence appears?
Four Historical Examples
In a very unscientific screen, we quickly found the four cases below with similar “bearish” divergences:
Did Stocks Continue To Rise?
In these anecdotal cases, the divergence between market breadth and price did not help predict the end of a bull market. The table below shows the dates the divergences appeared in 1995, 1998, 2004, and 2006. The right side of the table shows how much further the market carried before the bull market morphed into a bear market.
Therefore, the answer to our question is:
Yes, it is possible for a bull market to continue for quite some time after a negative breadth divergence similar to the one in place now.
Divergences And The Weight Of The Evidence
Is the current divergence irrelevant? No, it has meaning, but it is one of many inputs to consider. Since the weight of the evidence has supported the bullish case over the last four weeks, that takes precedence over the potentially bearish divergence. Could the divergence be “right” and the market “wrong”? Yes, but (a) that is a lower probability outcome and (b) the rest of the evidence will shift if the divergence proves to be helpful, something that has not occurred yet. A tweet from earlier today sums up our approach to all divergences (bullish or bearish).
If the weight of the evidence begins to shift, we are happy to adjust as needed. For now, we continue to hold an equity-heavy (SPY) portfolio, with a relatively small and deflation-friendly stake in bonds (TLT).
Volume Speaks To Conviction
Since every stock trade has a buyer and a seller, stocks do not rise when there are more buyers than sellers (something that is not possible). Instead, prices rise when the conviction to buy is greater than the conviction to sell. It can be thought of this way under bullish conditions, “I am willing to sell to you, but you are going to have to pay up”. The market recently provided us with a new conviction signal via a breadth indicator tied to volume…what could it mean for stocks?
The NYSE Advance–Decline (AD) Volume indicator is calculated by taking the total volume of advancing stocks and subtracting the total volume of declining stocks. All things being equal, stock market bulls prefer to see this indicator rise. The chart below describes the recent move that is noteworthy from a risk management perspective.
A Picture Is Worth A Thousand Words
Since early 2013, the present day market is starting to look more like 2003-2007, rather than the more volatile 2010-2012 period. The AD Volume signal was helpful in both periods, but is more relevant on the chart below. The green lines show signals similar to the one that recently occurred. The bottom of the chart shows the subsequent performance in the S&P 500. The chart is a weekly chart, meaning the gains in the S&P 500 (green arrows) occurred over several weeks or several months. The signal was also helpful during the financial crisis; the indicator never said “get back in” as stocks tanked (red arrow).
Investment Implications – The Weight Of The Evidence
Since there is no such thing as a perfect indicator, we do not use this (or any) signal in isolation. Like many other market tools or data, the signal above speaks to probabilities. Probabilities acknowledge that good and bad things can happen in the markets. This signal tells us the probability of good things happening is higher today than it was in early October.
Other Areas Improving As Well
The improvement in market breadth aligns with the bigger picture probabilistic outlook described on November 17. Since the weight of the evidence has moved from unfavorable in early October to favorable, our market model has been adding to our stock holdings (SPY) over the last four weeks. If the bulls maintain control, the evidence may call for further reduction in what is now a relatively modest stake in bonds (TLT). The evidence showed enough improvement to prudently add risk to our portfolios on October 21 (see tweet below).
We also noted the odds seemed to be improving in the October article Stocks: Is It Time To Get Back In?.
ECB Ready To Act
In a familiar theme of words and little in the way of action, the head of the European Central Bank was jawboning again Monday. From The Wall Street Journal:
“The European Central Bank is willing to take additional easing steps including purchases of government bonds if needed to keep inflation from staying too low for too long, ECB President Mario Draghi said Monday. Mr. Draghi’s remarks, in testimony to the European Parliament, underscored the central bank’s commitment to expand its balance sheet—the value of assets it holds—and if necessary widen its stimulus efforts to ensure that inflation rises back to the ECB’s target of just below 2%.”
The theme of ongoing “easy money” ties in nicely with what history says about the current stock rally in the United States.
Rare And Unprecedented
Since numerous rare occurrences, including the massive V-type rally in stocks, could skew the current landscape from a historical perspective, it is important we remain open to all outcomes (bullish, bearish, and sideways). However, it is also prudent to ask:
Can we learn anything from similar rallies in the last 10 years?
Just as meteorological conditions shift slowly over time between the middle of summer and the dead of winter, markets experience observable changes as a bottom is formed after a correction and during the subsequent rally. The market was weak (temperature of roughly 13 degrees) just prior to the October 15 low. Since then, conditions have improved relative to the market’s profile (temperature of roughly 83 on November 7, 2014). How has the market performed in the past after moving from a profile of 13 to 83? That question is explored in this week’s video.
The table below is described in the video above, along with charts showing numerous examples from recent history.
Investment Implications – The Weight Of The Evidence
Regular readers know our approach frowns upon forecasting and instead allocates based on the facts we have in hand. Therefore, the exercise above is simply about exploring the range of possibilities based on recent history. The market may go sideways or it may go down, but history tells us upside is also a realistic outcome in the months ahead. Based on the evidence we have in hand, our market model is calling for a heavy weight to equities (SPY), complemented by a modest stake in bonds (TLT). If the bulls can carry the market over the 2043 to 2046 level this week, the evidence may call for another incremental add to our stock ETF holdings.
ECB image Adam Baker Flickr
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Fundamental And Technical Alignment?
From a probability perspective, the best investment ideas tend to be those with improving fundamentals and improving technicals (charts). On the fundamental side, the news has been improving for homebuilders. From Fox Business:
D.R. Horton Inc, the largest U.S. homebuilder, reported better-than-expected quarterly revenue and said orders jumped 38 percent, suggesting an uptick in housing demand. The company, which caters to people buying their first or second homes, said the number of homes sold rose 25 percent to 8,612 in the fourth quarter ended Sept. 30.…Luxury homebuilder Toll Brothers Inc said on Monday its orders jumped in terms of both dollars and units for the first time in four quarters.
From Laggard To Leader?
The weekly chart below shows the performance of homebuilders relative to the S&P 500 Index. The trend turned against homebuilders in early March 2014. Since the October low in stocks, rather than lagging, homebuilders have been leading. The three steps required for a bullish trend change are nearing completion: (1) a break of a trendline, (2) a higher low, and (3) a higher high. The weekly higher high does not officially go into the books until this Friday, meaning homebuilders still have some work to finish.
Similar improvement can be seen when comparing the performance of homebuilders to a basket of bonds (AGG).
We would hope that investing in homebuilders would be better than a strategy to short the S&P 500 (SH). Until recently, that was not the case as the ITB:SH ratio was making a series of lower highs and lower lows (see chart below). The trend is trying to turn in the favor of homebuilders.
How Do We Use All This?
Investing is about probabilities. The improving fundamental and technicals in the housing sector tell us the odds of success in that sector are also improving. It should be noted that even if the weekly trends continue and homebuilders lead, that does not remove normal retracements and pullbacks from the equation. The odds of good things happening in homebuilders are better today than they were in early October. From a bigger picture perspective, the improvements in the market’s tolerance for risk outlined on October 31 and November 7 still apply.
House image from Alex via Flickr
Consumer Discretionary Underperforming
The chart below shows the performance of consumer discretionary stocks relative to consumer staples. For most of 2013, discretionary sectors were leading defensive sectors (ratio was rising in 2013). 2014 has been a different story with more conservative stocks, such as Proctor and Gamble (PG), taking on a leadership role.
Is This A Major Red Flag For The Bull Market?
While there is no question defensive leadership speaks to a more tentative market, have the bulls ever remained in control under similar circumstances? This week’s video provides some historical insight, along with how the Fed may be impacting the XLY vs. XLP ratio.
Earnings Provide Some Insight
Dean Foods and Toll Brothers both provided some backing for the bullish case Monday by reporting better than expected profits and sales projections. From Bloomberg:
“The numbers in the third quarter showed a steady economy, we continue to have oil below $80, consumers feeling confident, low interest rates, and that’s a combination that works well for stocks,” Mark Kepner, an equity trader at Chatham, New Jersey-based Themis Trading LLC, said by phone. “Central banks have also been quite accommodative in what they’ve been saying and it seems to be working.”
Investment Implications – The Weight Of The Evidence
If defensive leadership becomes a problem for the current rally, deterioration in the market’s tolerance for risk will begin to spill over into other areas, something that we have not seen yet. In fact, the observable evidence continues to show improvement, allowing us to reduce exposure to conservative assets (TLT) while increasing exposure to equities (VOO). With a relatively light economic calendar this week, the market may focus on earnings in the United States and abroad.