Mid-week market update: For the last two days, the SPX tested the 3000 level and its 200 day moving average levels and finally broke up today. However, market breadth presents a mixed picture. Fresh 52-week highs have been understandably strong for NASDAQ stocks, as they have been the recent leadership. However, new highs for both large and small caps are less than impressive, which calls into question the sustainability of this rally.
Who wins the knife fight at the 3000 and 200 dma? Here are bull and bear cases.
The bull case: The rally broadens
The main bull case rests on the constructive nature of the changing market leadership. The old price momentum leaders of US over global, growth over value, and large caps over small caps have faltered. In the place, leadership is broadening out to previous laggards such a small cap, cyclical, and value stocks.
Cyclical stocks are turning up on a relative basis.
The relationship between the reopening stocks and stay-at-home stocks is stabilizing, and may be turning up, indicating a renewal of risk appetite.
The breadth of the market strength is indeed impressive. Eurozone stocks are attempting an upside breakout, though the leadership is narrow and only limited to Germany.
The UK is also testing a key resistance level.
Ed Clissold, chief strategist at Ned Davis Research, makes the case that the broadening breadth is supportive of a sustained advance. 90% of stocks are now above their 50 dma, which is a bullish development.
The bear case: What cyclical turnaround?
The bear case begins with long-term concerns. Some technicians have pointed to the nascent small cap as a possible sign of an economic revival, which has signaled cyclical recoveries and major market bottoms. While I am sympathetic to that view, this indicator has shown hit-and-miss results and produced false positive signals in the past.
I know that traders aren’t supposed to care about valuation, but the small cap leadership is a sign of a cyclical recovery thesis is undermined by the highly stretched valuation of small stocks. The forward P/E ratio of the small cap Russell 2000 is literally at an off-the-charts high because of a low E in the P/E ratio. Instead, we can analyze the forward P/E ratio of the S&P 600 small cap index, which has a more stringent profitability index inclusion criteria. The S&P 600 also trades at a historical high at 22.0 times forward earnings.
Speaking of valuation, value stocks are not exactly cheap from a historical perspective either. While investors can expect some valuation refuge in value names, downside risk is still considerable should the market mood turn negative.
Despite the recent rally, the bulls still have much work to do from a long-term technical perspective. The monthly MACD indicator is a long way from flashing a buy signal, and such buy signals have been extremely effective at calling fresh bull markets in the past.
The idea of broadening leadership is an attractive idea from a conceptual perspective, there is no sign of new leadership from a global perspective. US stocks have stalled relative to the MSCI All-Country World Index (ACWI), but the same could be said of Europe, Japan, and emerging markets. All regions have been moving sideways on a relative basis for the past 4-8 weeks.
The fickle narrative
So where does that leave us? It might just up the market’s animal spirits to decide on the market narrative of the day. Joe Wiesenthal at Bloomberg is watching how some of the more aggressive US states are reopening their economy, and the change in COVID-19 cases as a way of monitoring the market’s mood.
The green lines show OpenTable seating data for restaurants in Georgia, Florida, and Texas (three of the earliest and most aggressive states in terms of reopening). The red lines show the daily percentage change in total coronavirus cases in each of those states. The key thing is that all the lines keep going in the right direction. If the return to normal starts setting off a new wave of cases, that will be a red flag. Or if dining activity stalls out at a very depressed level, that would be ominous as well. And it’s certainly possible that service sector activity could just hit a ceiling as a substantial portion of the public changes their behavior. But for now, all the lines are going in the right direction.
As traders have learned in the past couple of months, the market’s mood can be very fickle. While the market’s focus today might be focused on the progress of reopening efforts, it might shift its gaze tomorrow to the deterioration in Sino-American relations tomorrow. Secretary of State Pompeo has declared that Hong Kong is no longer autonomous from China, signaling a possible end to special trade relationship with the territory. As well, Reuters just reported that a Canadian court has ruled against Huawei CFO Meng Wanzhou’s case against extradition.
Meng’s lawyers argued that the case should be thrown out because the alleged offences were not a crime in Canada.
But British Columbia’s Superior Court Associate Chief Justice Heather Holmes disagreed, ruling the legal standard of double criminality had been met.
“Ms. Meng’s approach … would seriously limit Canada’s ability to fulfill its international obligations in the extradition context for fraud and other economic crimes,” Holmes said.
The ruling paves the way for the extradition hearing to proceed to the second phase starting June, examining whether Canadian officials followed the law while arresting Meng.
There is also the prospect of quantitative tightening as the Fed eases its foot off the QE pedal.
In the short run, market breadth was already overbought based on Tuesday night’s close. While the odds favor a pullback, the market has also been known to advance on a series of “good overbought” readings.
I am closely watching the signals from the credit market. The relative price performance of high yield (junk) bonds and municipals are exhibiting minor negative divergences against stock prices. This is especially important in light of the lack of earnings in the Russell 2000, which is indicative of the low credit quality of that index’s constituents. The relative strength of small caps and the relative performance of HY bonds is an important relationship to keep an eye on.
The Trend Asset Allocation Model’s readings have turned from bearish to neutral, and my inner investor is reluctantly and slowly adding equity exposure from an underweight to a neutral position by focusing on buy-write strategies (long stock, short call option) to mitigate downside risk. If I had to guess, the range of my market scenarios for the next six months calls for a 40% chance that the market would revisit its March lows, 40% chance of a wide range-bound market, and a 20% chance that the market would push higher.
My inner trader is confused by this market action. He is standing on the sidelines.