Is The Equity Market Topping?

Topics Covered

• Narrowing breadth speaks of an equity market top
• Narrow trading range for Long Bond Treasury prices
• Silver finds itself at a major technical decision point 

Weekly Overview

The mean reversion rally continues, helped by the announcement coming out of the Eurozone. Main beneficiaries so far have been commodity prices, especially Crude Oil which has rallied over 10% in less than a week. Agriculture is taking off, despite an abundance of bears calling for lower prices, with Wheat now at $8 a bushel. The bottom line still remains the same: investors are fearful of a disorderly default in the Eurozone and intense funding pressure on large economies like Spain and Italy. At the same time, Asia and especially China is slowing down meaningfully. At present, bearish trades remain slightly crowded, but not as much as they were at the start of the month.

Global Macro

Nothing new to report. Refer to the side menu for previous articles.

Economic Data

Nothing new to report. Refer to the side menu for previous articles.

Equity Markets

The title of this update reads: "Is The Equity Market Topping?" First of all, let me explain what I mean by that question. Market tops are a process and not an event. Therefore it takes months, sometimes even quarters for the market to establish a topping pattern. Afterwards, it also takes months for the market to slowly start declining before the downtrend becomes obvious to many. What I am doing here is investigating the possibility of current conditions meeting that of a market topping process. So let us start...

One of the most important lessons I got taught from reading Marc Faber's newsletters over the years (highly recommend his subscription over at Gloom Boom & Doom) is that equity markets will discount majority of the recovery very early on. In other words, majority of the gains within the current bull market occur at the beginning of the rally. In the chart above, thanks to the UBS newsletter, we can notice that within the first 12 months S&P 500 gained about 80% and since then it has been a bunch of volatility with barely any progress - 12% gain in 24 months or 6 percent per annum. That is one of the first signs that the current cyclical bull market, which started in March 2009, is ageing and slowing down. A side note: obviously traders will comment on how there is large amount of money to be made in between those swings - fair enough. This is a post about the next major move in markets, not the next minor swing.

When I see signs of stalling gains and equity prices going nowhere for multiple quarters, I automatically refer to my statistical research of all major bull and bear markets since 1920s, which we can see in the chart above. To read the table properly, please focus on the bull market length in weeks and gains in % terms on the left hand side; and disregard the bear market section on the right hand side. Let us summarise some important points:

• The current cyclical bull market for S&P 500 is actually much older (173 weeks) than the average cyclical bull market (155 weeks) in all periods since 1920s. Furthermore, it is also dramatically older than all cyclical bull markets during secular bear phases like the one that started in 2000 (134 weeks vs 173 weeks). 

• The current cyclical bull market for S&P 500 has gained more (106%) than the average cyclical bull market (99%) in all periods since 1920s. Furthermore, the gains for cyclical bull markets during secular bear market phases tend to be stronger on average, but here too we have done better (104% vs 106%). 

Statistically speaking, the current cyclical bull market is approaching old man age while it has managed to more than double from its lows; therefore the most likely outcome is that we are in the last inning of this cycle. In other words, a topping process has most likely already began. Let us focus on the market breadth to further scrutinise this theory.

Currently, S&P 500 is only 3% away from its 52 week highs. Majority of the bulls would claim that this type of price action shows remarkable strength, especially with the Eurozone backdrop constantly making investors nervous. However, things do not look that healthy for the internal market dynamics. If someone told me that S&P is only 3 or so percent away from making a new bull market high, I would image broad breadth participation. Quite to the contrary, the chart above shows that we actually have less than ⅔ of stocks above the 200 day moving average or in an uptrend. Two major points to consider regarding this observation:

• S&P 500 itself is 73 points or 5.5% above its 200 day MA, while less than ⅔ of the index are above their respective 200 day MAs, indicating that the current rally is pushed higher by fewer and fewer index components.

• Last time S&P 500 traded in 1370s range was in the middle of April 2012. At the same time, the breadth readings back than were around 80 plus percent of stocks above the respective 200 day MAs, which is far less than today despite same price range.

These are not the only worries I have regarding internal market breadth. It has becomes obvious to a keen market observer that more and more "fundamentally strong" stocks are breaking down from their uptrends. The recent ones worth noting are McDonalds, Nike, Google, Caterpillar, Procter & Gamble among others. Furthermore, in general there are less and less stocks making new 52 week highs since this bull market began in March 2009 for both NY Stock Exchange as well as Nasdaq Stock Exchange. That tells us the fuel tank is starting to approach the empty signal. Finally, breadth weakness is also evident by following S&P 500 index against the S&P 500 equally weighted index (known as the Value Line). The Value Line never properly confirmed new S&P highs in 2012 and furthermore, has been under performing the official index since May 2011.

Moving along, let us also examine the recent rally out of early June lows. I would like to make another observation: the recent S&P 500 rally has mainly been of defensive sector rotating nature. Price action of Utilities, Staples, Telecom and Health Care are making new highs in the current bull market; while economically sensitive cyclical sectors like Technology, Discretionary, Financials and Industrials are posting anaemic bounce rallies at best. Furthermore, the table above shows that the long term breadth in these cyclical sectors is below par, especially with Technology and Semiconductors, where the breadth is below 50% readings.

In early 2007 as the S&P 500 was making new highs both the Financial as well as Discretionary sectors were under-performing on a relative basis.  This was the beginning of a topping process and by March 2008 the market was falling hard. In early 2011 both Technology and Financial sectors started under performing on a relative basis. This also proved to be a top for the S&P and by August 2011 the market crashed as it came within 1% of an official 20% bear decline. Currently, we can conclude that on a relative basis against the S&P index, cyclical sectors that are highly sensitive to the economy, are breaking down on a relative basis once again. Most likely another topping process has begun.

And while Mr Market is giving us keen observers "hints" that not all is right within the current bull market, majority of global fund managers are not listening. Recent Merrill Lynch Fund Managers Survey showed that relative to its decade long history, Technology and Discretionary sectors are heavily overweighted right now. As a matter of fact, Discretionary is close to 2 standard deviations overweight. I find it remarkable that fund managers are this bullish at present just as the economy is starting to weaken meaningfully around the globe.

In summary, the equity market has more than doubled since the recovery began in early 2009. The current bull market holds characteristics of very stagnant percent gains, a very ageing advance (in weeks), narrowing participation of breadth and finally an under-performing economically sensitive sector rotation. All in all, I would argue that the US equity market topping process has now officially begun. In all honesty however, the majority of other global risk assets already peaked during the more orthodox top of May 2011. These include global equities from Europe to Asia, high yielding global currencies and industrial commodities. 

While I do not think short positions are in order automatically as of today, I do think certain sectors are now officially close to or already at a top. Also to consider is the complacency of investors when looking at the VIX in the chart above, which is now once again trading in the so called "danger zone" range of 15 to 20. Furthermore, market timers should also consider that McClellan's Oscillator is very overbought right now, while medium term breadth measures like stocks above 50 day MA are most likely signalling more weakness ahead.

Bond Markets

Further to the equity update above, I would like to quickly cover two technical price setups in the Treasury Long Bond and Silver market, which I find of high interest right now.

There is quite a small trading range within the 30 Yr Treasury Long Bond price, which I found very interesting. Volatility has died down and the price has been calm for over a month now. I believe a decently strong move in either direction could now take hold. Keep your eye on this one, especially if you are a shorter term trader who loves using leverage / margin with tight stop losses. Furthermore, I will participate in the rectangle by trading it either long or short depending on which way it breaks.

Currency Markets

Nothing new to report. Refer to the side menu for previous articles.

Commodity Markets

Silver has been in a decline of lower highs and lower lows for over 13 months now. During that period, the price action has formed a very noticeable downtrend line. At the same time, while the Euro has been making lower lows, Silver's solid support at $26 has so far held its ground. Today, we basically have a pressure point or a triangulation, where the price will now have to make a major decision (chart below). We either break the support at $26 and the downtrend continues; or we break out above the downtrend line as well as the 50 day MA and move upwards. At that point, we could also have another go at breaking above the 200 day MA in coming weeks as well.

Personally, I hold a lot of Silver in my portfolio regardless of the current technical setup. As a matter of fact, those who follow the blog on regular basis would remember that both of my major purchases during current cyclical bear market have been around the $26 / $27 mark (one in late December and one just recently). I am not sure which way the price action is going to move and if the move itself will be self sustaining, but if someone put a gun to my head today and said "break down or break out?" I would be bullish right here. Primary reasons are of contrarian nature, where investors were recently heavily exposed to US Dollar and at the same time Silver's sentiment is extremely negative. Furthermore, I will participate in the triangle by trading it either long or short depending on which way it breaks, without changing my long term Silver investments.

Credit Markets

Nothing new to report. Refer to the side menu for previous articles.

Trading Dairy Update

• Fundamental Outlook: I believe that we approaching another bear market as the recovery loses steam. I am not sure if politicians can hold it off until elections in both US and Germany pass, but 2013 and 2014 will most likely be bad years. US GDP has grown 5 quarters at around 2% or lower which is stall speed. Over the last 60 years, whenever the economy grows at subpar levels it has always entered a recession. At the same time earnings and margins are at record highs, so I expect that they will mean revert. During recessions since the 1950s, earnings tend to fall on average by 25%, so a drop to $70 from current levels in earnings could take the S&P 500 down below 1,000 points (P/E = 12 * $70).  Cash levels in money market funds are as low as 1998/99 and 2006/07, so I believe investors are extremely exposed to risk assets. Corporate credit spreads are very narrow relative to economic fundamentals, so I expect they will widen dramatically in due time. Recessions occur every 3 to 4 years of expansion during secular bear markets, so in 2013 or 2014 we are overdue for a slowdown (but it could be much earlier).

• Current Positioning: I've positioned myself towards long PMs especially Silver (large position in my fund) and have recently just accumulated more, because I believe central banks will continue to print money and devalue currencies whenever the economy gets worse. Furthermore, investors were recently heavily exposed to US Dollar, so from a contrarian point it also makes sense. On the other side of my book, I want to hedge my longs by being short stocks, especially the much loved Consumer Discretionary and Technology sectors. Furthermore, I also want to be short high yielding risk bonds like emerging markets and junk, as I think spreads here will widen dramatically during a recession. Finally, I want to be short Asian & Commodity export currencies as I believe CBs will cut rates as global economy slows.

• Asset Watch-list: On the long side, commodities still remain on my watch list. These include Commodity Indices (GCC / RJI), Brent Crude (BNO), Precious Metals (CEF, SLV, PSLV) and Agriculture (RJA / MOS). I believe commodities are very oversold right now especially Crude Oil's and Silver's sentiment. As already mentioned, I've recently bought more Silver on the long side, but will not do anything more until I hear stronger action response from the Fed or until European crisis plays out its final leg. On the short side, Tech sector (XLK) & Discretionary sector (XLY) are on my list of stock shorts. I am also looking at Emerging Market bonds (EMB) and Junk bonds (HYG) as a potential short as well. Finally, a major short in due time will be US Treasury long bonds (TLT), but I believe we are just not there yet. I have not done anything on the short side just yet but I am slowly gearing up to open some shorts for the first time since 2008.

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