Weekend update 11/28/2014

Black Friday closed with ominous note: Breath deteriorated substantially and sentiment turned even more defensive. The backdrop for the turbulence is the plunge oil price the directly hurts energy sector and related high yield bonds. The high yield dropped and treasuries rose. The continuing divergence between the high yield and treasuries is the most dangerous alarm of rising risk aversion that is yet to affect the large cap stocks. Other divergences:

Against the breath weakness across variety of assets, Friday also showed a sharp move in treasuries that has previously indicated near term weakness in stocks:

All indications point to weakness in the coming week.

Continuing divergence between credit and stocks

The stocks made new all time high today on thin volume but credit continues in other direction. The credit spread has  moved opposite of stocks all year:

To understand why this is important, see "Why credit spread matters". 

In a more near term movement, 10 year treasury price has made a strong move up:

Similar move preceded the October price stock market down move. SKEW remains elevated (SKEW>135 for third time in four days). I do not expect much to happen on Friday's short trading day but the next big move should be down.

Interesting credit move signals the intermidiate market top

The ten year credit made a relatively big move today. Similar move preceded the mini correction in October.

Why credit spread matters

Credit spread, the difference between risky bonds and risk free treasuries is a good indicator of investor risk tolerance. Widening credit spread indicates that investors are becoming more risk averse and are seeking safety in treasury bonds. This sentiment is reflected in the stock market. Figure 1 (top panel) shows the correlation between changes in credit spread and SP500 price. The correlation is not perfect (they never are) but this is about as good as one gets in finance.

Figure 1: Correlation between credit spread changes and SP500.

Periods of widening credit spread (red line on bottom panel) can be very risky for stock market.  This indicator alone is not sufficient in avoiding all market drops and it has given a few false warnings. Where it has worked big time is in avoiding large draw downs in 2000 and 2008. This indicator has also worked well since 2009.

Currently (11/25/2014), the credit spread is giving another warning. Combined with lofty valuations, the caution is doubly warranted.

Re-establishing correlation between large caps and small caps

The relative under performance of small caps have been a theme of 2014. For bears, this has been indication of risk aversion and top formation. But what if the small caps were just waiting for the large caps to catch up?

Figure 1: After over-performing in 2013, the small caps have waited for the large caps to catch up.

The market is nearing a decision point: Several indicators are still divergent but the market breath and uniformity have also been on the mend. Now that the large caps and small caps have re-established their correlation, the next move for them will likely be in the same direction. 

Another up week with weakening breath

Looking at SP500 price action, this week was another strong up week. Momentum was fading a bit but irrelevant Chinese interest rate news  drove the market up on Friday. The gap up ended in doji in many indexes (see for SOXX example below) sets up potential for reversal on Monday.

Figure 1: Gap up and doji. Exhaustion?

Is this the exhaustion that marks the market reversal? Next weeks will tell. Meanwhile, here are some clues:

1. Skew > 135 for both Thursday and Friday. Historically this has meant high risk for correction.

2. Even with this week rally in large caps, market breath is weak.

Figure 2: Breath is weak.

3. Defensive sectors are still leading.

Figure 3: Defensive stocks stronger than cyclicals.

4. Oscillators are starting to roll over. This is too already to call. Typically, the oscillators will need to turn negative before an air pocket. But given the nervousness in the market, fast drops cannot be ruled out.

Figure 4: McCellan and MACD are starting to roll over.

Overall, we have a strong set-up for reversal in next few weeks.

Incremental high at weaker breath

US large caps are still advancing but the rally is getting hollower. The market breath is not a timing indicator but reversal is getting likelier by the day.

Figure 1: Market breath as of 11/20/2014

Buy and hold for the next decade

As I note in "Market breath is bad and deteriorating"  on 11/17/2014, now is not a good time to buy stocks:There is a strong risk that stocks will be lower in one year time frame. Long term buy and hold investors have different horizon. What can they expect for the next decade?

In the long run, the investment return is sum of dividend return and price change. In long term, the price tends to mean revert to value. This allows estimation of the long term stock market returns shown in Figure 1.

Figure 1: Modeled and actual historical stock market return (dividend + price change).

The model is not perfect (how could it be?) but correlation is significant. Based on this, the annualized return for the next decade is about 5%. This is well below historical returns as the stocks are overvalued compared to historical norm. As shown next, this may actually be the Goldilocks case. 

The inflation adjusted historical returns are lower. Shown in Figure 2, adjusted for inflation, the stock market returns can be negative for a long period of time. The 70's high inflation was a investment equivalent of hell. This is the real danger of buy and hold in the current environment: Should the central banks succeed in releasing the inflation, the future stock returns could significantly underperform the model return of 5%.  

Figure 2: Modeled and actual inflation adjusted historical stock market return (dividend + price change).

Defensive stocks is leading into the rally

SP500 is extending all time highs at increasingly shaky market breath. Defensive sectors are leading (utilities, staples) and risk sectors are lagging (cyclicals, small caps, industries, and high yield bonds). Divergences such as this need to be resolved one way or the other. My take is that we are at or near the top.

Why? Last time we saw divergence as this was in 2011 before a correction. The divergence is more mature now but this just makes it harder for stocks to keep advancing.

Market breath is bad and deteriorating

Market breath or uniformity is one of the most consistent early warnings of trend change. Currently, the breath is flashing alarm. The reversal may not be imminent but history teaches that it is coming.