"Nervous investors have socked $3.4 trillion away in cash. But stocks are rising and their nerves are calming, leading bulls to view the huge cash pile as a sign that markets have room to go higher.
Assets in money-market funds have grown by $1 trillion over the past three years to their highest level in around a decade, according to Lipper data. A variety of factors are fueling the flows, from higher money-market rates to concerns over the health of the 10-year economic expansion and an aging bull market."
-- Wall Street Journal, November 5, 2019
The S&P 500 Index (SPX - 3,093.08) has been in a rapid ascent since breaking out. Moreover, it’s brushed off headline risks as of late pertaining to the U.S.-China trade war and impeachment inquiries. So, should we be asking ourselves, “Are we once again climbing a wall of worry?” as the market often likes to do? Maybe… structurally, the market looks solid from a technical perspective. After a 21-month consolidation in a secular bull market, we’re back in blue-sky territory, so why isn’t everybody celebrating? Likely, because there are some real risks out there from an economic perspective. Also, because investors are sitting on a large pile of cash that is not participating in the recent move, and fortunately for them, this market has the potential for a bullish pullback, in our opinion.
As we noted last week, from a technical perspective, the market broke out from a textbook ascending triangle pattern and has since swiftly climbed to the 3,080 level, which we noted was an area that could see some hesitation since it also happens to be the 10% level from the round 2,800. The short-term trend gives us a little more than 1% upside to the 3,125 area, where we’ll run into the upper trendline connecting the May 2019 and July 2019 highs. Breaking the steep short-term trendline would likely set us for a retest of the breakout, which would be constructive in my opinion. However, if the market wants to put some doubts in traders, it will likely overshoot to the lower bounds or 2,950, an area which coincides with the underfollowed 160-day moving average.
We’re also starting to see risk-on assets break out, like in the iShares MSCI Emerging Markets ETF (EEM – 43.68), which have been in a downtrend since Q1 2018, even in the face of continued weakening economic data coming out of China. So, are market participants getting their appetite back for risk-taking? Possibly. We’ve also been seeing a mild rotation out of defensive names like Staples and Utilities, both of which have led this market higher in 2019. Some of this is certainly because the CBOE 10-year Treasury Yield Index (TNX – 19.33) had rallied hard over the past few weeks, all the way back to the point of the breakdown in early July, when the Fed signaled it might cut rates at the July meeting.
"While the risk of a recession has increased dramatically -- as I discussed a month ago, with defensive sectors outperforming and economic data starting to deteriorate -- it doesn't mean we need to have a hard landing. Recent history leads us to believe that this is the only kind of recession possible, but throughout time we've had mild recessions, particularly during secular bull markets that were spurred by technological innovation and growth."
-- Monday Morning Outlook, August 19, 2019
Economically we’ve been getting some mixed data, and market participants are doing their best to shake off the scary parts. To alleviate some of these worries, the Federal Open Market Committee (FOMC) cut rates for a third time this year to support the expansion. The yield curve spooked investors earlier this year, which I’ve written about multiple times over the past year. Certainly, the damage may have been done, as the inversion has predicted the last seven of nine recessions.
One thing that feels different from the usual signal is the fact it steepened rather quickly, and the last time we saw that happen was in 1998 when the FOMC acted aggressively by cutting rates three times. The following year the SPX was up 19.39%. Sound familiar? Since the yield curve inversion, we’ve also seen some worse-than-expected readings from the Institute for Supply Management (ISM) reporting. The CEO Business Confidence also stirred up some gloomy outlooks, while the jobs numbers and consumer confidence have remained fairly upbeat. However, it should be noted that they are lagging indicators.
When looking at the ISM’s purchasing managers index, we saw an uptick in the data to 48.3 in October, even though it was lower than expectations. This is also at a critical spot, as September’s reading was the lowest since June 2009, and a further decline would be worrisome, especially if we go below the 45 level since all recent recessions have coincided with a drop below that level. However, we’ve seen plenty of manufacturing slowdowns that have not derailed the market or the economy at large as you can see in the chart above.
Furthermore, we have a divergence in CEO Business Confidence and Consumer Confidence readings. While this does typically happen before recessions we should be mindful that business leaders have been conservative with capital expenditures this whole cycle -- a behavior likely adopted from the last crisis. Although, since they started recording CEO Business Confidence Survey in 1976, we’ve never seen a reading below 40 that has not preceded a recession. So, while this data continues to cause jitters among investors, it still hasn’t been reflected in the market price action, nor has any hard data breached levels that would cause real concerns just yet.
While this market may not present immediate structural risks, it does present some sentiment risks. The Options Clearing Corporate (OCC) all-exchange, equity-only, 10-day option put/call volume ratio is rolling from one extreme to the other and is currently nearing the lower end of its typical range at 0.75, and is telling us there is some exuberance among market participants within the options market. Additionally, SPDR S&P 500 ETF Trust (SPY - 308.94) implied volatility levels are in the low end of their range at 10%. And while never a harbinger itself -- and a better indicator that buying option premium is preferential to selling premium in the current market environment -- implied volatilities are typically in the lower end of the range before volatility spikes during sell-offs.
One thing that might dampen the chances of a large pullback is the Cboe Volatility Index (VIX - 12.07) 20-day buy-to-open call/put ratio, which is at 2.14 after a sharp drop. As we’ve mentioned before, we typically see a surge in call buying above 7.00 before market pullbacks, although the indicator has been hard to time, as pullbacks have occurred anywhere from days to weeks later. However, Commitments of Traders (CoT) large speculators, who are notoriously on the wrong side of the trade, are once again at a record-setting VIX futures short position this week. I expect any short-term pullback that would create a rapid uptick in volatility would be followed by aggressive covering in these positions and likely reallocating to equity positions.
Finally, market breadth has seemed to lag what we would expect in a traditional breakout. The percentage of stocks trading above their 50-day moving average has yet to break out with the broader market, while the percentage of stocks trading above their 200-day moving average is approaching overbought levels. Some strategists have pointed out the divergence in the percentage of stocks trading above their 50-day moving average this past week, but I wouldn’t look too far into the divergence. First, I think this is the wrong way to look at the indicator. We’re still trading near the higher end of the range of its historical range at 66.53%.
Secondly, looking back to 2017 when the SPX returned 18.47%, it spent half the year below the level we're currently at. Thirdly, any pullback and reallocation of cash on the sidelines would likely push this percentage higher as it will likely pour into broad-based index ETFs. In regard to the percentage of stocks trading above their 200-day being overbought, when you look back through time, they can do this for quite a while. So, while it could mean a pullback is on the horizon, it’s hard to use it as a timing tool since it can remain this way for weeks or even months.
When looking at other breadth indicators, we are seeing some interesting data points coming from the advance-decline issuances. The S&P 500 Advance-Decline has stalled this past week as the market continues to rally. Additionally, the NASDAQ Advance-Decline has been lagging the whole rally, but when digging a bit deeper and looking at the NASDAQ Advance-Decline Volume we see it confirms the breakout. All these breadth indicators are telling us that this market is being led by fewer stocks, whereas we like to see robust breadth for bull rallies to be sustained.
There are few ways to play a potential bullish pullback in the coming weeks. Since SPY implied volatility is at the low end of its range, you could buy puts for a speculative bet or as a hedge against a long portfolio. Another way might be to consider some volatility calls in anticipation of a volatility pop. Just be prepared to flip the switch to bullish positioning at the support levels mentioned earlier, because we remain in a secular bull market and just broke out after a 21-month consolidation.
Matthew Timpane is Schaeffer's Senior Market Strategist.
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