Sunday, July 31, 2016

Signs of an Approaching Top

As expected the past week could only be called choppy with almost daily cycles between an SPX low of 2160 and a high of 2175 to close the week at 2174.  Besides the sentiment indicators that I will cover later, several headwinds will face the market over the next two months.  The first is an interesting take on the "seasonality effect" that many call "sell in May" shown at Mauldin Economics.  Here John shows that the traditional flat period from May to October shows up from 1950-2015, but when looking only from 1988, a top usually occurs in late July and bottoms in late September.  The second, from Marketwatch, shows the markets have been supported by active global central bankers, mostty ECB and BoJ, even as the Fed has pulled back on QE, but recent actions indicate less willingness for further QE-like activity.  Finally, sightings of the Zika virus have started to appear in S. Florida.

What I have noticed the last couple of weeks, is that commodities are starting to weaken, especially oil, and we are seeing a rotation into the tech stocks   Looking at the NDX at 4730, it is only 10 points from the May 2015 high and about 120 points from the ATH in 2000, but sentiment shows that at least a short term top is near with short interest on the QQQ near the Dec 2015 levels.  My own ETF ratios for the 2x QID/QLD and 3x SQQQ/TQQQ show the same low level of bearish sentiment.

Looking at the two composite indicators this week, the overall Indicator Scoreboard (16 weighted) and the Short Term Indicator (VXX $ Vol and Smart Beta PC).  The Indicator Scoreboard EMAs are at the lowest levels seen in the last 18 months and the Short Term Indicator is showing the same.  

Conclusion.  Last week I was looking for a top in the SPX 2185 area, but the market has struggled to reach that level.  Combining the seasonal factors with the extremely low bearish sentiment may point to a high early this week as the first two trading days of the month are usually positive due to mutual fund inflows.  An additional warning was issued by the VIX P/C with a reading of 1.58 Friday due to a large put volume, and the last time this occurred was June 23 just prior to the BREXIT decline.

Weekly Trade Alert.  I am still using SPX 2185 as a shorting target with a stop at 2198 and a short term target of 2135, probably to be followed by an opt exp week rally.  Updates at @mrktsignals.

Appendix.  My special rant this week is to point out the weakness of the overall put/call ratio CPC Revised compared to the Smart Beta PC.  The CPC Revised is an improvement of the reported CPC by backing out the VIX puts and calls, but still has problems identifying tops, typically leading by several weeks.

The Smart Beta PC (ETF puts/Equity calls) does a much better job of indicating market turns, particularly the BREEXIT bottom.

Sunday, July 24, 2016

Revisiting the Composites

Last week, I looked at a number of individual indicators, some bullish some bearish, with the conclusion that choppy price action was likely.  This week, I want to take a longer time view back to January 2015 and compare the action of the various composites I have been using.

To review, here are the composites in reverse chronological order to usage:

  • CompositeST, combines the VXX $ Volume and Smart Beta P/C as the highest correlated with statistical test on short term returns
  • CompositeWTD, combines 16 indicators weighted by correlation with returns
  • Students Trifecta, combines the VIX term structure, TRIN, and overbought/oversold indicator, created by the Humble Student
  • Composite#2, combines the CPC Rev, VXX $ Vol, and VIX term structure
  • Composite#1, combines the SPX P/C, VXX $ Vol, and SKEW.
First to show the VIX P/C, which does not support an immediate bearish outcome, but a more likely choppy period ahead.  Until the VIX P/C drops below 0.50, the SPX could continue in a similar pattern to early 2015, then in January the markets saw a sharp but short drop that quickly reversed for a gain two times the loss before leveling off.

The CompositeST paints a completely different story with a near vertical drop, resembling the July 2015 period more than the  February 2015 period.

The CompositeWTD matches the extremes seen at other market tops since January of 2015, but does differentiate between the 2015 tops of February and July.

The Students Trifecta, which I haven't mentioned for several months, did reverse from a SELL in April to a BUY in June and is currently in the same position as the 2015 tops in February and November.

The Composite#2, influenced heavily by P/C ratios, shows an extreme most similar to the April-May period of 2015.

The Composite#1, influenced heavily by P/C ratios, shows an extreme that was only shown at the November 2015 top.

Conclusion.  Virtually all of the composites point to strong indications of a near term top, but several different topping patterns are possible.  Personally, I still prefer the 2007 analog mentioned last week, but until I see lower VIX P/C ratios a choppy price behavior is more likely.

Weekly trade alert.  As posted at @mrktsignals, I did take a stab at shorting the SPX at 2168, but was stopped out the Friday on a reversal for a 2 pt loss.  Next week, I am looking for the 2185 area to re-short. Given how quickly the 1 year unemployment claims have fallen since June, the FOMC may come out hawkish again and  that could repeat last week's Thursday selloff, Friday recover pattern.

Saturday, July 16, 2016

Long and Short Term Views

I apologize in advance for the longer than usual length of this post but there are many things to cover.  First, over the past few weeks I have been making fun of other analysts that seem to change from bull to bear depending on market trend, so in the interest of full disclosure I want to point out my long term view published in March of 2015.  Second I want to go into more detail than usual on the short term view, comparing indicators that support conflicting bearish and bullish views.  If you are only interested in the latter, please skip the next section.

Long Term Views

Early 2015 I wanted to see if there were fundamental reasons to support the seeming high valuation of the stock market and developed a valuation approach, based on the dividend discount model using the 10 year T-bond as the discount rate.  Full article.  The results going back to 1980 were that as the economy slowed and interest rates dropped by 50%, the fair value of the DJIA doubled.  The forecast for mid-2016 were a GDP growth of about 0.5%, the 10 year bond near 1% and the fair value of the DJIA at 18,514.  Extracted below:

  • My most likely scenario. The recent rise in the dollar and collapse of the Euro has certainly clarified what I see as “no way out”. It is likely that the US economy will enter row five the first half of next year as the economy slows down and 10-yr rates approach 1%. However, by the second half of next year the collapse in the Euro should turnaround the EU economy, possibly sharply. As to US stocks, low growth will push valuations up to DJIA 18514. I expect the price levels to increase by the change in valuation or to about 27000 by the end of next year. A small “snap back” may be seen in the traditional May-Oct selloff period in 2015.

As you can see, the second half of my prediction calls for a melt up starting the second half 2016.  This was before I even thought of developing a sentiment model, but now my long term views are somewhat more tempered (more like the view of Jeremy Grantham at GMO) and I hope to update my long term forecast by the Fall.

Short Term Views

Bearish sentiment has been dropping like a rock, led by the put/call ratios as shown by my CPC Revised (less VIX puts and calls), whereas money flow indicators as shown by the SDS/SSO and SPXU/UPRO are only now approaching the mean sentiment levels.  The two most reliable indicators for the short term of 2-4 weeks based on the March 23 statistical tests are the Smart Beta P/C (ETF puts/Equity calls) and the VXX $ Volume 
 I have combined these into a short term composite that is moderately below the mean. The major tell so far has been the VIX P/C which usually drops to 30% at tops as smart money loads up on VIX calls and is now in the 50-60% range.

The overall Indicator Scoreboard (composite of 16 indicators) has now dropped to its lowest level of the year, although the speed of the decline leaves some room for the longer term EMAs to catch up through a consolidation before a decline.

The CPC Revised put/call ratio has dropped to an extremely low level essentially in a mirror image of the January rise indicating the possibility of a significant top for the SPX, both in price and time.  Comparing this behavior to the Jan - Feb bottom, a higher high can still be achieved after a correction with sentiment at less extreme levels.

Looking at the money flow indicators (SPX 2x and 3x ETF ratios), the more conservative (2x) SDS/SSO ratio saw a very unusual jump in bearish sentiment almost matching the levels of the Aug and Jan declines, which turned out to be a warning of a sharp rally as fund flow reversed.  Sentiment has now reached a neutral level.

The more aggressive (3x) SPXU/UPRO had a much less extreme reaction to the BREXIT scare and has reversed the run up in bearish sentiment to match the level of the July 2015 top.

The Smart Beta P/C (ETF puts/Equity calls) showed a similar extreme in bearishness to the SDS/SSO ratio which made me wonder about its effectiveness but did prevent me from being prematurely bearish.  This indicator is now possibly several days away from reaching the levels of the July 2015 top.

The VXX $ Volume has now reached the level of several short term tops over the past year.  Interestingly there was a pickup in volume on Friday with about one-third of the volume after hours when the Turkey coup attempt was announced.  Unwinding these trades will probably provide upward price pressure for early next week.

Combining the last two indicators with the best short term return correlations (2-4 weeks), I will now be using a short term composite (CompositeST) as shown below.  For future posts I will be mostly referring to the two composites.

Finally, the VIX P/C, which does not track well statistically due to its bipolar nature (high call buying at tops by smart money and at bottoms by dumb money).  Over the past year high P/C has resulted in choppy markets, both up and down, while low P/C has preceded all of the sharp declines.  So, I would not expect any sharp declines just yet.

Conclusion.  A top of some magnitude is approaching.  For those of you that like historical analogs, the period from July 2007 to Oct 2007 is probably the closest to my favorite scenario.  Here, we saw a slight ATH in July compared to 2000 for the SPX, a 10% decline in August, then a rally to new ATHs in Oct.  Due to the election, a win by the Democrats would be seen as a win for the status quo and may drag the top into mid-Nov.  Many of the sentiment indicators show that longer term EMAs have not reached the sell level and with the high VIX P/C, we are likely to see choppy trading until that happens.

Weekly trade alert.  Due to the proximity to a top, I am willing to short at the SPX 2165 level with a stop at 2180 and a target of 2080.  With the failed coup in Turkey, we could see a pop on Mon/Tue then a short term falloff.  Due to the choppy nature expected, I may use trailing stops.  Updates at @mrktsignals.

Sunday, July 10, 2016

Not a Lot to Say

The title pretty says it all for this week.  Everyone who was calling for the end of the world by this Fall (e.g., PUGS) has now decided to look skyward for SPX 2500 which has me suspicious, but maybe this time is different.  I was surprised by the speed that the SPX reached 2130, but this was not unlike what happened in July 2015, so the Zika scenario I posted last week is still on the table.

So let's move on to the sentiment update.  The composite Indicator Scoreboard shows the average weighted sentiment is still following the July 2015 scenario where a quick run up to SPX 2130ish was followed by a loss of momentum then a retest of the recent lows (SPX 2070s).  Sentiment levels are also still at equivalent levels.

To offset the somewhat bearish implications of a repeat of the July-Aug 2015 market behavior, I want to take a look at the small cap RUT using the TZA/TNA ETF ratio.  Here we see that as the SPX fell below 2000 with the BREXIT the RUT actually fell below its Aug 2015 low and bearish sentiment spiked to similar levels.  Overall the price pattern of the RUT appears similar to a giant IHS pattern with bullish implications.  For the overall market, this seems to imply a less bearish outcome than Aug 2015 should a post-Olympic Zika pandemic scare occur, probably limiting the downside to the low 1900s to be followed by higher highs.

Finally, its time to take a look at gold stocks using the DUST/NUGT ETF.  I have not shown this since the Dec-Jan lows after pointing out the overwhelming bearish sentiment the last half of 2015.  Admittedly, I expected the HUI to stall out in the low 200s and the recent spike is likely due to fears of the BREXIT fallout. That being said, there is no reason to expect an imminent collapse.  One thing I look for is balance, or amount of time above the mean compared to time below the mean and another two or three months of extremely low bearishness is expected.

Conclusion.  I was actually hoping to recommend a rally to test the ATH this week based on the SKEW dropping to the low 120s, but Fridays rally preempted it.  So my overall strategy is to wait and see if there is a set up for July-Aug 2015 scenario.

Weekly trade alert.  None at this time.  I was considering the SPY expiring calls at Thursday's close based on the low SKEW only to watch the 210's go up 5x and the 211s up 10x on Friday. Updates @mrktsignals.

Monday, July 4, 2016

Is It Time to Light the Fireworks

Last week I mentioned an analog to July 2015 which saw a sharp drop over several days (less that 100 SPX pts) then an equally sharp rally over 5 days that eventually made a slightly higher high.  At the time I did not foresee a repeat without a "do whatever it takes" by the worlds central bankers, but that seemed to be exactly what happened.

Why is that important now?  After the sudden rise in 2015, the market consolidated for six weeks as bearish sentiment plummeted, then late August when the bears were in hibernation the bottom fell out.  The reason I am bring this up is that this year the summer Olympics are being held in Rio, the capital of the Zika virus.  The Olympics will be over August 21st, so don't be surprised if there is a repeat of the Oct 2014 pandemic scare. The key as always is the level of bearish sentiment, so I will be watching very closely to see if there is a repeat of the 2015 sentiment pattern.  See Rio bacteria.

For the overall sentiment charts, I am going to start using a 1 one year period for the intermediate term and six months for the short term.  First looking at the intermediate term Indicator Scoreboard composite, bearish sentiment peaked at an almost identical level as in July 2015 and has started retreating, a move down to the Sell level at -1 SD would be a strong warning for August.

The short term sentiment chart highlights how quickly the bearish sentiment has started to fall.

Conclusion.  The biggest change in any sentiment indicator was in the SKEW, which dropped from a high of 154 on Tue to 128 by Friday (less bearish), so not much indication of a nasty surprise to weak earnings.  Falling bearish sentiment means less likelihood of significant upside fireworks, So looking for several weeks of consolidation with a slightly positive bias.

Weekly trade alert.  I probably should have been more bullish on Mon, but I was looking for a lower retest aka July 2015 bottom, but at least picked up a few pts on early drop.  Likely no trades till August.  Updates @mrkt signals.