$SPY - Grindstone Intelligence

July 15, 2019

An Update On Market Breadth

The concept of breadth is pretty simple: the more stocks that participate in a trend, the stronger that trend is. All 3 major stock indexes in the United States set new weekly highs, but how strong is the trend?

The cumulative advance-decline line might be the most well-known breadth indicator. The calculation is easily understood (the difference between rising issues and falling issues at the close is added to the previous day’s value), and it has reliably diverged before many of the largest bear markets. It’s a good place to start for a market breadth review. Right now, advance-decline is signaling the all clear – as the indexes have set new highs, so has the cumulative A/D line.

The percent of stocks above their 200-day moving average is healthy, too. Moving averages are, by definition, lagging indicators, and recent studies have cast doubt around their reliability as trading signals, but I find them useful as a litmus test. When an issue trades above a moving average, it’s hard to argue that it’s in a downtrend (and vice versa). Right now, 74% of stocks are above their long-term moving average. That’s just as good as anything we’ve seen since the January 2018 peak.

The number of stocks setting new highs and new lows is somewhat weaker. As the market has rallied over the past month, the New Highs index has set a string of lower highs. This divergence is a cause for concern, but divergences are not meaningful unless they’re confirmed by a price reversal. A larger red flag will be raised if we start to see an expansion in new lows accompany the decline in new highs.

The measures above are some of the most common ways to look at breadth, but it’s also important to account for the current environment. Stocks have struggled to gain traction since the run-up that ended in January 2018. They tried to break higher last October, but failed in dramatic fashion and fell 20% by Christmas Eve. When the S&P 500 rallied and first exceeded its 2018 highs in April of this year, only 182 of the 505 members had done the same – a 7% correction followed. As of this writing, 221 members have exceeded their 2018 highs at some point this year – a significant improvement, but still less than half. Those readings are somewhat comparable to the latter half of 2016, when the first breakout attempt (September 2016) had only 39% participation and resulted in failure, but the successful second attempt (November 2016) had 50% participation.

The picture deteriorates somewhat when you look at current prices. Only 177 constituents (35%) are currently trading above the 2018 resistance. Additionally, Utilities and Real Estate are the only positive sectors, with all but 16 of their combined 60 members trading above 2018 peaks. The majority of stocks in each of the other 8 sectors are beneath those key levels.

Put simply, broad swaths of the market are still stuck below resistance – the median stock in the S&P 500 is 7.5% below its 2018 high. Participation could clearly be better, but it’s less clear whether it’s weak enough to necessitate another correction. Markets are regularly led by a few strong names, and they can drive prices higher for longer than anyone expects. One thing I’m sure of: a broadening in participation would be extremely healthy for stocks as we move forward, but the cyclical sectors have some work to do.

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.

June 10, 2019

Bad vs. Less Good: The U.S. Economy

On Friday, the S&P 500 closed at 2873.34. For those of you keeping track at home, that’s a whopping 0.02% return since the January 26, 2018 peak. (If you prefer the Total Return measure, that’s enough annualized return to keep even with the current inflation rate.) When it comes down to it, stocks have done next to nothing for almost 18 months. It might seem that given a relatively unchanged equity market, the economic environment must also be relatively unchanged. That isn’t the case.

The year 2017 was highlighted by ‘synchronized global growth’ – economic activity increased around the world, accompanied by stock prices. The good times continued throughout the first month of 2018, and, even after a global equity selloff in February, data for most of last year indicated that underlying fundamental growth would continue. New highs for U.S. stocks in September seemed to confirm that everything was fine, but then a steep 4^th quarter selloff and the ensuing rally brought us right back where we started.

Following the trend in year-over-year equity returns, the economic data has more recently softened. But is the data actually bad, or just less good? Let’s take a look.

You can’t get much broader than GDP. After breaching 4% in the middle of 2018, growth in the United States declined to 3.2% in Q1 2019 just above the 2.3% average since 2010. The St. Louis Fed’s GDPNow estimate points to continued slowing in Q2 2019 (1.39%), but no contraction.(Click charts to enlarge)

The unemployment rate is at 3.9%, the lowest in nearly 50 years and much better than the 70-year average of 5.8%. But the rate of jobs growth is slowing. Friday’s BLS report showed a subpar addition of only 75,000 jobs. A similarly weak print in January was written off as a ‘blip’, but two blips start to resemble a change in the trend. Moreover, a separate measure of payrolls from ADP showed a decline of 35,000 jobs in construction, accompanied by losses in manufacturing and natural resources. Those aren’t things we want to see in May, when outdoor activity should be picking up. Weather might have been the cause, but weather is like alcohol – it tends to get blamed for a lot of things it didn’t do.

Survey data doesn’t inspire much confidence either. While the services side has held up better, the Markit Manufacturing PMI has declined from its 2018 peak of 56.5 to 50.5 – still above the 50.0 flatline, but the lowest reading since 2009. The New Orders component of the survey, generally considered a leading indicator, is in contraction.

Profit margins for companies in the S&P 500 peaked last year (in case you haven’t noticed, this is a recurring theme). Rising labor costs and tariff impacts, among other things, have reduced margins from 12% to 10.9%. On the bright side, that’s the same nominal benefit received from the 2017 tax cuts, so the net change over the last 2 years is essentially zero.

We round it out with earnings. S&P 500 earnings per share are estimated to set a new all time high in 2019, which has helped reduce the forward P/E multiple from 18.5x to 16.2x. Year-over-year growth in earnings is less exciting. The first quarter of 2019 actually saw earnings decline according to FactSet’s blended calculation, and almost all of the anticipated gain for the calendar year is expected to come in the final months. Additionally, consensus EPS estimates typically trend down over time, so full-year growth projections should always be treated with skepticism.

What’s Next?

The weaker data has caused a major shift in expectations for Federal Reserve action. After 3 hikes in 2018, Federal Funds futures markets in October had priced in, with over 90% certainty, at least one more hike by December 2019. The forecasters have since reversed course – not only are they pricing a 0% chance of a hike, the odds now suggest a 99% chance of an interest rate cut.

The aforementioned easing in monetary policy has been categorized as an ‘insurance cut’, intended to offset tariff impacts and stimulate inflation rather than counter an economy already in decline. As reinforcement, FOMC members have been careful to say that no recession is imminent, but economists don’t have the best track record when it comes to predicting recessions (more on that later).

To sum it up, most of the data is still just less good, as opposed to being outright bad, and the Fed seems to have our backs if things do deteriorate further. A weaker economic outlook suggests a cautious approach to equities, but remember, equities discount the future. A break to new highs for the S&P 500 may foreshadow an improvement in data, just like it preceded the slowdown in 2018 (alternatively, a break to new lows might signal a coming recession). But as of today, neither is the case – equities are still rangebound and economic data is mixed. We aren’t out of the woods yet.

May 20, 2019

It’s Getting Harder to Be a Day Trader

Full Disclosure: I’ve never actually been a day trader. It might be the golden age of day trading for all I know, but I do know a major change has taken place since 2016. No, I’m not talking about a certain Twitter addict. I’m talking about futures markets.

The CME launched the E-mini S&P 500 futures contract in 1997, and they can be traded nearly around the clock. If Russia declared war on the United States at 2:30 tomorrow morning, you could instantly sell some futures contracts rather than waiting for the cash market open (that’s not a recommendation for what you should do if Russia declares war tonight. In fact, you should probably find shelter). Transactions in the overnight futures market have an impact on where stocks open for trading every morning, and gaps (differences between opening and closing prices) are accounting for more and more equity market gains.

To gauge the impact of after-hours trading on market returns, I created two performance indexes: Daylight and Overnight. The first ‘buys’ the S&P 500 cash open at 9:30 ET and ‘sells’ the closing print at 4:30 ET. The second ‘buys’ the S&P 500 cash close and ‘sells’ the open on the following morning.

There was a time when the overnight session barely mattered. (Click charts to view them full screen)

The Daylight index (Red), excluding its superior performance during the financial crisis, tracked the S&P 500 (Black) with near perfection from 1998 to 2013. Unsurprisingly, the two had a near perfect positive correlation. Even through the first half of 2016, 3 years after the Overnight index (Blue) began to show consistent signs of life, the correlation held steady.

But the winds changed in the middle of 2016.

The correlation between the Daylight index and the S&P 500, while still high, has notably deteriorated since then. More importantly, the Overnight index has outperformed the Daylight index from that point in August 2016 to now. In fact, it’s accounted for about 70% of the S&P 500 gains over that time. If you’ve been day trading, maybe it’s time you took up night trading instead.

Another perplexing trend is a divergence in performance over the past few weeks.

Since early May, the S&P 500 has fallen more than 4% in the overnight trading sessions but has been up over 2% between the opening and closing bells. I can’t find a comparable period of such sustained and conflicting movement in after-hours trading. Even if I could, with only 3 years of relevant data, I wouldn’t have much confidence in assessing what it’s meant in the past. I certainly don’t know what it means for the future.

What I do know is this:

Gone are the days when markets truly closed. More than ever, being a money manager is a 24-hour gig.

Questions or Comments? Let me know