Equity Market Persistence

Equity markets sold off in early trading to the tune of -0.7% reaching a low of 1854 on the SPX. As the day progressed, that trade was completely unwound and the SPX went unchanged by midday. The SPX closed about 0.8% off its all time high of 1883.57 reached on March 7 with the initial reaction to the Employment Situation report. Economic releases have been light this week with Retail Sales, Jobless Claims, and the Producer Price Index still to come, but I think it is likely that markets are still fluctuating from the Employment Situation report last Friday. As a reminder, the SPX began the year at 1848.36 and equity market performance continues to exhibit a plateauing pattern.

Focus has turned to Copper prices and their implication for the Chinese economy. Copper has long been a coincident indicator for the global economy, but has become more and more an indicator of the Chinese economy given thier industrial growth and Copper’s ties to China’s financial system. The price of Copper is down about 13 percent YTD and down about four percent this week alone. Concern is spreading that a slowdown in China will have global economic impact.

Those implications are longer term in nature and investors should expect a modest trading range over the next few days.

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A Note on December Performance

The month of December is an overwhelmingly positive month for US equities.  Take a look at the table below:


So it is surprising to see the SPX down 1.31% through the first 8 days of this month.  Below is a comparison to previous December performances through the first 8 trading days (December 2013 is highlighted).


The month is far from over and SPX levels are nowhere near correction territory.  As the month progresses, we’ll continue to look for other indicators that are breaking historical trend; mindful of the FOMC decision coming on December 18.

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What to Expect in 2014; A Historical Review

The following chart displays SPX calendar year returns since 1950, in ascending order; 2013 is highlighted.


The SPX is a long way from having its best year ever, but 2013 is currently among its top 10.  Barring an FOMC decision on December 18th to taper the current pace of quantitative easing, the SPX will remain there.  Two thousand thirteen was very much the year of the Fed (we’ll get to that chart in a later post).

Going back two months, consensus estimates for a December taper were in the significant minority.  As an ironic side note, looking at consensus estimates from one year ago, a December 2013 taper was also in the significant minority; with the majority estimating a Fed taper around June 2013.  To be clear, a continuation of quantitative easing is a statement of the Fed’s belief that the economy is not healthy enough to persist on its own.

Does 2014 have the performance potential of 2013?  The following chart plots returns (y-axis) and realized volatility (x-axis) for the SPX (1950 – 2012).


For perspective, I’ve highlighted the years following >25% calendar year returns (with the crosshairs indicating 2013’s performance and realized volatility levels).  If the past is any indication, 2014 will bring lower returns and/or higher volatility.  That is not to say a 20% performance with a 13 realized volatility level is a bad year, though.

The next chart is a modification on the first–displaying the next calendar year’s maximum decline from that year’s close.  For instance, 1954 is plotted on the far right with the largest drawdown over the next 12 months from the 1954 close (not intra-year declines).


Aside from the 17% pullback in 1990, none of the other 11 best performing years saw a price more than six percent lower from year-end.  A six percent decline from current levels equates to about 1700 on the SPX.

With only seven calendar years producing higher SPX returns since 1950, it is probably safe to assume that 2014 will produce returns less than +25%; and a pickup in volatility is also probably warranted.  But that doesn’t necessarily mean 2014 is due for a correction in equity markets.

Waiting on the Fed to ease their monetary stance from hyper-aggressive has proven too conservative over the past year.  The upcoming year will also be Fed dependent and tapering QE will be a large obstacle for equity markets to face.

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Lowered Holiday Spending Forecasts – Gallup

Consumer psychology is highly fluid and data dependent, so don’t be confused by the following conflicting responses.

U.S. consumers now estimate they will spend $704 on Christmas gifts this season, down from their $786 average prediction in October. Americans’ latest estimate is also significantly below the $770 they forecasted at this time last year. – Gallup


At the same time, on a non-quantitative basis, these same consumers suggest that they plan to spend “about the same” to slightly more than last year.

Gallup-HolidaySpending2Several events over the past three months likely contributed to the mixed signals, including uncertainty within the political environment and all-time highs in U.S. equities.

As far as this data relates to U.S. equities, there may not be a downside.  Given that the current quantitative easing policy will likely stay in place at least until March, any reduced expectations in holiday spending allow for subsequent upside surprises.  That is, the “worst case scenario” is that consumers spend less and quantitative easing continues at its current pace through March.  The “best case scenario” is that consumers outspend expectations and quantitative easing continues through March.

Source: Gallup


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U.S. Equity Mutual Fund Flows


It is hard to find a more real-time quantitative indicator of the retail investor than mutual fund flows.  After five years of very strong US equity market performance, the so-called “mom-and-pop” investors are beginning to view equity investments in a more positive light.

These investors are undoubtedly late to rally and their strategy will likely, as it already has, result in sub-par returns with excessive volatility. Are retail investors a contra-indicator? Yes, but that doesn’t mean an equity correction is imminent either.

After a long enough time of pounding the table with regard to the pitfalls of behavioral risk (e.g. emotional investing), I anticipated that I wouldn’t have been phased by the continually-flawed investment process of the aggregate retail investor.  But human nature is human nature; and given enough time, cycles will infallibly repeat.

Consider the following:


Source: WSJ (paywall)

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Only The Second Sell Off Of The Year

The US economy is in its 11th quarter of “recovery”; and by all standards, this “recovery” is sub-par.  The reason the economy is in this recovery—rather than 11+ quarters of decline—is due of the combination of 2 factors: ultra-low interest rates and a federal reserve that is monetizing US debt.  In the short term, there are very few consequences to monetizing the debt, specifically because the US Dollar is world’s reserve currency.  Long-term consequences are another story.

From this perspective, there are four catalysts for the price of gold:  the actual short-term and long-term consequences as well as the current perceptions of each.  The Federal Reserve has committed to an accommodative monetary policy for a long time; I suspect it will be longer than most people think, but that is irrelevant to this discussion.

The actual consequences of low interest rates and a devaluation of the dollar are supportive of the price of gold in both the short-term and long-term—although for different reasons.  In the short-term, a devaluation of the US Dollar via monetary policy is a natural positive catalyst.  In the long-term, ineffective US fiscal policy and a realignment of global currencies (a.k.a. “The Currency Wars”) is also a strong case for a higher price in gold.

Evaluating the perceived consequences is a more difficult task; and I think this is where the recent weakness has come from.  I would list the negatives as follows:

  • A move higher in the SPX
  • A general complacency in equities as represented by the VIX
  • The regime change in Japan
  • Euro-area comments regarding currency devaluation

My view:  volatility will gradually pick up as uncertainty comes back into play as the intermittently transient Euro-Zone and US fiscal problems are once again in the purview of investors.  I’ve previously noted SPX price studies that suggest a slightly bullish movement to the SPX—to the tune of 1% to 2%.  Well, that was when the SPX was around 1515 and it just may have put that +1% move higher to 1530 on Tuesday.  The upside is limited in equities and they have become much riskier as time passes without a more significant sell off.  It is too early to tell whether February 20th will mark the beginning of the correction in equities, but the smart strategy is to continue to reduce long equity exposure.

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SPX Return Since Feb 1: +0.47%

There is very little on the economic calendar over the course of the next two weeks.  Of note are the 10-Year and 30-Year Treasury Auctions this week (Wednesday and Thursday, respectively).  The FOMC Minutes will be released next Wednesday, February 20th.  Then we get to March 1 and the Spending Sequester, which several prominent politicians have recently come out stating that it is likely to take place.  The question is, are the expectations and implications of this “priced in”.

Today’s 10-Year auction came in rather mixed, with the highest yield since March 2012.  Much of the data and sentiment in 2013 feels eerily similar to the beginning of 2012.  This could be the start to the “great rotation” or it could be just another head fake.

And for your reality check, below is a clip from CNBC six years ago this week:


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A Study in SPX Price Momentum

The NYSE experienced a low volume session today.  Among the factors responsible for this could be:

  • Chinese New Year (China’s markets are closed all week)
  • NEMO (effects of which still linger)
  • State of the Union Address (Tuesday)
  • VIX expiration (Wednesday)
  • Less demand for equities at this level

What might be a more accurate phrasing for that last bullet point is:

  • Hesitation and/or uncertainty about short-term direction

The SPX rose for six consecutive weeks (as of last Friday).  Going back to 1957, there have been 93 other occurrences in which the S&P 500 Index rose 6 consecutive weeks or more.  The results of which are slightly positive.

Over the course of the next two weeks (following six consecutive weeks of price gains), the SPX:

  • Increased 60% of the time (56 occasions)
  • Gained an average of 0.59%
  • At worst, returned -2.91%
  • At best, returned 4.74%

Over the course of the next four weeks (following six consecutive weeks of price gains), the SPX:

  • Increased 68% of the time (62 occasions)
  • Gained an average of 0.96%
  • At worst, returned -6.99%
  • At best, returned 6.87%

Over the course of the next 13 weeks (following six consecutive weeks of price gains), the SPX:

  • Increased 71% of the time (66 occasions)
  • Gained an average of 2.64%
  • At worst, returned -9.84%
  • At best, returned 12.68%

In relation to those 93 prior occurrences, the return over the past six weeks has been slightly more positive than average; 8.24% compared with an average 6.96%.  While the possibility of outcomes is, as always, wide and every situation unique, history suggests (on average) a limited upside from here in the near term–one to two percent.  I expressed this likelihood last week.

I’m not suggesting equities are extremely overbought at this point; mainly because this sort of sustained momentum tends to feed on itself.  However, I also don’t think there are strong enough catalysts to propel equities to the high ends of historical ranges (i.e. the price study described above) without a minor correction (read:  better buying opportunity) first.

Much of the YTD gains (4.65%) came in the first 14 trading sessions of the year.  Over the last 14 trading sessions, gains are much more modest at 1.64%.  Whether this is a sign that equities are rolling over or just proceeding at a more realistic pace, what is apparent is that the rest of 2013 will not proceed with the same velocity and consistent upside as January.

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Fourth Quarter GDP “Anomalies” Fully Priced In

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A Matter Of The Utmost Importance

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