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The Standard and Poor’s 500 Index (SPX) has been trapped in a sideways trading channel for the past couple of months. SPX dramatically broke out of that channel on Friday, closing at $2128, down $53 or 2.4%. SPX gapped lower Friday morning, opening at $2169, and didn’t even pause as it broke the 50 day moving average (dma) and then took out long-term support at $2160. Even more ominously, all three major broad based indices, SPX, RUT and the NASDAQ Composite, closed at their intraday lows. This type of close is very bearish; go back and study the charts preceding the August flash crash from last year.
What triggered this breakout? The best answer appears to be recent interviews with two FOMC members suggesting a rate hike may come as soon as the Fed meeting later this month. This certainly isn’t the first time that the market has seemed to freak out over a quarter point interest rate move. To my mind, it doesn’t make any more sense this time than it has previously. Interest rates are going to remain below one percent for the balance of 2016 in all plausible scenarios. Would that increase in interest rates throw cold water on business expansion plans? I seriously doubt it. For that reason, I think this correction will be brief, but that doesn’t mean we should just sit on our hands.
On the other hand, perhaps weak economic data, such as one percent GDP growth, and a string of five consecutive quarters of declining corporate earnings, are beginning to weigh on the market. The Russell 2000 Index (RUT) closed Friday at $1219, down $39 or 3.1%. RUT has been trading higher since the BREXIT panic, so Friday’s large move wasn’t a breakout from a sideways channel as it was with SPX. RUT closed on Friday near a solid support level around $1220. RUT remains as the only major market index that has failed to make new all-time highs over the past couple of months. The lagging behavior of RUT as other indices traded higher suggested some restraint on the part of the bulls. But RUT’s smaller drop on Friday also suggests that the bearish action has not fully impacted the small caps as yet. If we see a solid break of the 50 dma on Monday, that would underscore the bearish move.
Volatility spiked much higher on Friday, with the VIX closing at 17.5%, up five points in one day. Those of you speculating with VIX calls are celebrating this weekend.
Given the backdrop of weak GDP growth and declining corporate earnings, a bearish move certainly shouldn’t be surprising. The surprise is the suddenness of the move and the move being attributed to the possibility of the Fed increasing interest rates at the meeting this month. Perhaps this is just one more illustration of a nervous market that can turn on a dime in either direction, e.g., the BREXIT panic resulting in a large price decline for only two days, followed by a prolonged bullish run higher.
The Federal Reserve has historically maintained a strong non-political posture. I don’t think that is likely to change, so the prospect of the FOMC raising interest rates on September 21st, less than two months ahead of the presidential election, seems very unlikely. Thus, I would not expect Friday’s significant price drop to continue on Monday, which is why I held my positions on Friday, and even sold some far OTM SPX put spreads. But if this decline continues on Monday, I will be aggressively closing and/or hedging positions.
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The Standard and Poor’s 500 Index (SPX) closed today at $2180, up $9. SPX has been trading in a tight channel from $2157 up to $2194 over the past seven weeks. This channel has been reinforced over the past couple of weeks by the shadows of the candlesticks. Pull up a chart of SPX and observe how the upper and lower candlestick shadows define support and resistance.
The bulls and the bears are in a closely matched tug of war. The bulls are being held in check by poor economic data, such as one percent GDP growth, and a string of five consecutive quarters of declining corporate earnings. On the other hand, the bears can’t manage to take control and drive the market lower primarily because the FOMC has left interest rates at record lows.
Trading volume in the S&P 500 continues to run below average with neither the bulls nor the bears able to sustain a strong push. SPX trading volume has only increased enough to touch the 50-day moving average (dma) a couple of times during August.
The Russell 2000 Index (RUT) price chart presents a different picture from SPX in two key respects. First, RUT has been trading higher rather consistently since the BREXIT panic. Today’s close at $1252, up $12, is the high for RUT for 2016. But the second difference between RUT and SPX is that SPX has set several
all-time highs over the past few weeks. RUT remains 4% below its high from last year at $1296.
This lagging behavior of RUT suggests some restraint on the part of the bulls. They are not sufficiently confident to “go all in” and strongly buy the small cap stocks. But the persistent trending of RUT higher as SPX is trapped in a sideways channel may suggest that the bulls are gaining confidence.
GDP growth rates of one percent or less are on the brink of recession. At best, we have a very lackluster economic environment. When I add five consecutive quarters of declining corporate earnings, I am seriously concerned about our economy. But then I look at the market prices. How long can this continue?
Be cautious.
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The title of this song from one of my favorite bands, Queen, came to mind today as I thought about today's price action. This bull market, that by all measures should not be continuing higher, did just that again today. SPX tacked on another six points to close at $2190, while RUT spurted higher by $12 to close at $1242. And the NASDAQ Composite did not want to be outdone, gapping open this morning and gaining $29 to close at another all-time high at $5262. All-time highs are becoming passe.
Many valuation measures, such as the price to earnings ratio and the average dividend yield of the S&P 500, suggest a pricey market. We are nearing the end of the second quarter earnings announcement cycle, and earnings have declined once again on a year over year basis. When you think about it, the only way the P/E for the S&P 500 may continue to rise is that share prices are rising faster than earnings are declining. At its most fundamental level, stocks are priced on the value of the discounted cash flow of the projected earnings. Yet prices continue higher as earnings decline.
Don't misunderstand. I am not trying to say the market has it all wrong. The ultimate arbiter is the market price. But that brings me back to the title, Another One Bites the Dust. In this context, another bear covers his shorts. Where does it end? No one knows. But it is clear that we are increasingly on thin ice.
So what should we be doing in this market? I don't presume to have all the answers, but my trading boils down to a few bullet points:
- I am continuing to play bullish stocks as they trade higher. But I am using diagonal call spreads to give myself some safety margin on the downside, just in case the market pulls back one of these days.
- I am closing profitable trades early to lock in gains. If I can bank 70-75% of the potential gains on a trade, I take it.
- As I position my non-directional trades, I am allowing for more safety margin on the up side. I am not betting against the bull.
- I am as nervous as a long tailed cat in a room full of rocking chairs.
Make money while you can, but be careful out there.
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The Standard and Poor’s 500 Index (SPX) set a new all-time high on August 15th and tried to reach that number again on August 23rd, but it has faltered since then. Janet Yellen spoke at the Jackson Hole economic conference at 10 am ET this morning, and SPX made its intraday high a few minutes later. But then the party ended. Traders decided another interest rate hike is coming and sold off. SPX reached a low around 2:30 pm ET but then recovered a bit to close at $2169, down $3. The second quarter GDP growth numbers, announced earlier this morning, with an annualized growth rate of 1.1%, probably didn’t help. That is pretty weak. FACTSET released the final earning results for the S&P 500 for the second quarter, down 3.2%. This is the fifth consecutive quarter of earnings declines. This is the first time we have seen a five quarter string of declines since 2008-2009.
However, SPX is holding up rather well. $2160 has set up as a solid support level and that is where SPX bounced today. If we break $2160, the next level to watch is the 50-day moving average (dma) at $2144. Trading volume in the S&P 500 companies has run below the 50 dma since August 8th. This market is certainly out of steam, but that doesn’t necessarily mean it is going over the cliff. SPX has been very resistant to the bearish arguments.
The Russell 2000 Index (RUT) just traded modestly higher this week, but closed at $1238 today, down two dollars. RUT was not able to match its highs from last year during this strong post-BREXIT run, a bearish sign.
After trading near 2016 lows last week, the SPX volatility Index (VIX) moved higher this week, opening Monday at 12.5% and closing today at 13.7%. Perhaps more significantly, VIX moved as high as 15% earlier today. I would guess the bounce of SPX off support at $2160 calmed some nerves.
A couple of weeks ago, I offered two possible driving forces behind the bullish post-BREXIT market:
1) Traders are buying with renewed confidence that the Fed won't raise interest rates before the end of the year.
2) We may be seeing the effects of global cash flows seeking a safe haven in our stock market. The global economy is slowing and, even though the U.S. economic data are mediocre at best, we are looking better than most.
With the market’s reaction to Yellen’s comments today, perhaps we are left with the “best house in the bad neighborhood” theory. It may be significant that the market did not trade lower this morning after the weak GDP growth numbers. Poor economic data continue to be ignored by this market. It appears to be primarily Fed driven, which would argue that a pull back won’t come until the FOMC actually raises interest rates. But will Yellen and company raise rates before the election? I doubt it. They don’t want to be seen as adding fuel to the fire for either side’s arguments.
Be cautious. This is a nervous market. As evidence, look at the three point intraday range of the VIX today.
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After Friday's huge move higher, it was natural to expect a little bit of a slowdown today. SPX lost $2 to close at $2181 and RUT was down a dollar to close at $1230. Volatility was essentially unchanged with the VIX at 11.5%. Trading volume slowed with 1.9 billion shares of the S&P 500 companies trading. Trading volume declined 10% on the NYSE and dropped 20% on NASDAQ.
Many of the big names have already made their earnings announcements for this cycle. We have NVDA later this week and CSCO and WMT next week. 86% of the S&P 500 have already reported and 69% beat analyst estimates, but that ignores the fact that earnings continue to decline on a year over year basis. According to FACTSET, the current earnings decline for the second quarter is -3.5%. If that number holds, it will be the fifth consecutive quarter of earnings declines. That has not happened since 2008-2009. In addition, guidance for the third quarter has been largely negative with 67% of companies offering lower guidance. FACTSET reports that the price to earnings ratio (P/E) of the S&P 500 now equals 17.0 on an 12 month forward looking basis. The five year average P/E is 14.7 and the ten year average P/E is 14.3. These data offer a quantitative basis for the commonly heard opinion that this market is overbought. However, overbought markets may remain overbought longer than I have funds to short the market.
But we are left with the question: What is driving this market higher? As we have seen above, the run higher certainly isn't based on stronger earnings streams. Maybe traders are buying with renewed confidence that the Fed won't raise interest rates before the end of the year. Another possibility is that we are seeing the effects of global cash flows into our stock market, i.e., the "best house in the bad neighborhood" theory. Our economic data are mediocre at best, but the U.S. stock market looks better than many other global markets.
So we are left with a quandary. The market's most probable direction is to continue higher, but a pull back or correction is overdue. We just don't know what may trigger the sell off or when that might occur.
I am continuing to trade bullish positions in this market, but I am favoring diagonal bull call spreads because those positions offer some downside protection if the stock or index pulls back. I am also positioning my non-directional trades with additional safety margin on the upside. And my stops are on a hair trigger.
Be safe out there.
