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.

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.