The 20% correction that wasn't

After a sustained rise, the market needs to scare off some weak hands in order to gather some energy to rise further.

Since 2016 the SPX climbed about 60% into the February 2018 top. This is not very much compared to other moves in history, but it was fast and without many retracements. Usually, such a move is followed by larger than usual corrections. In our case, the market should have fallen some 20%. Why 20% and not just the plain 7-10% benign correction? Because such a rise has created a bull herd that needs to dissolve before the market can advance further. Any further rise needs fresh buyers and the ones that participated in the current rise are already committed. They will only be fresh buyers if they are shaken out in the first place. And they will only be shaken out by a larger than usual correction.

It is by this kind of roller coaster that the manic-depressive business partner known by the name of Mr. Market makes it possible that he is the winner most of the time in any venture with traders.

So, this time, will it be - 20%, or  just - 10%?

I think it should be 20% given the high commitment into stocks. Just look back at what the market has done previously after this indicator has reached 0.4.

                                percent of assets held in euity. for more info go                                        to: http://www.philosophicaleconomics.com/2013/12/the-single-greatest-predictor-of-future-stock-market-returns/

But, given the steep drop we got in February and the attention it received, the market may have been able to shake out many bulls just by the 12% correction we got until now. This is very probable and if the market moves above 2700 it is the most probable scenario.                   

Flows into bond funds

I last commented on bonds here. It looked like there was still a lot of downside for bonds. Flows into bond funds confirm this! Lately, inflows reached extreme levels.

Flows into equity funds updated

The outflows continue. There was no episode of significant inflows since the lows in February 2016! I do not think that a more important top may take place before we see significant inflows into mutual funds.

Note: only flows into US mutual funds are considered. The chart is updated as of October 2017

Bonds

Here is a very long term chart of the 10 year Treasury futures contract. Previous reflation episodes were accompanied by multiyear 25% retracements on average. This time should be no different.

The New Bull

From time to time, it's best to tune out all the noise and just take a look at a chart. The emerging bull - Europe:

The Contrarian Approach

This bull has a long way to go:

Secular Bull Legs

Secular bull legs before corrections greater than 10%:

If the market falls

New highs next?

Subject:	Is the correction over at the August lows or not?
Last updated:	25.12.2015

H1	The rally from the low on Septemper 29 is the beginning of a new move to new highs.
H2	A new leg down will start soon.

Evidence	H1	H2	Comments
E1 - NYHL is showing some strength.	+	+	There is not enough strength to invalidate H2.
E2 - Short term macro indicators look ready to bounce.	+	+	This does not invalidate any of the hypothesis.
E3 - TRIN 13dma has shown some weakness  on the latest rally.	+	+	Anything can happen given the TRIN at these levels.
E4 - Everybody seems to be bearish, expecting a bigger correction, me included. (Jeffrey Saut said it after discussing with many fund managers).	+	-0.50
E5 - The November rally has been an opportunity for participants to exit massively from US equity funds.	-0.50	+	A first month of massive redemptions seems to have followed previous bigger corrections.
E6 - Indicators of breadth have been very weak. For example 22d adv. It has gotten oversold only on the consolidation in December.	-0.25	+	This could be just a measure of the extreme bearishness.
E7 - Valuation looks high. Profits are at extremes and they could start to fall, especially if the slowdown in the % yoy rate of GDP continues.	-0.50	+	This looks like a strong argument against new highs but valuation is always hard to time.
E8 - The LT trend has been higher and has not been broken. The correction can be enough (12-13%) in an ongoing secular bull.	+	-0.25	Another leg down would break the rising trend but not decisively.
E9 - The Fed has started to hike rates.	+	+	The hike could bring some turbulence but in previous hiking cycles,  equities have been higher after some time from the first hike.
Total:	-1.25	-0.75

Conclusion:

H2 is winning.  A new leg down will start soon. This conclusion neglects the signal given by the generalized bearishness, but this could be ok because weak sentiment is sometimes leading and, also, if the new leg down is short, the bearishness could be exacerbated, producing a very good buying opportunity. The main evidence that made H2 a winner are the massive exits from mutual funds and valuation. Are they reliable enough? I think so. Note that classical indicators (like breadth, momentum are not useful - they will only signal an entry point)

Falling Retail Sales and Falling Inflation

The series for Real Retail Sales shows a visible drop in the rate of growth, the kind that can be associated with a peaking business cycle, while Core CPI is resuming its downward trend, something that could suggest longer term structural weakness or just that the business cycle peak is farther away into the future.

Since the QE does not end until September given a $10bn tapering pace, the stock market seems to have enough time to complete another bull leg with 1900 - 1950 or even 2000 as possible target.

Weakness becomes visible

The big plunge in the New Orders Index comes as a a surprise, but weakness was expected.

The NFP report confirmed the slowdown with a visible fall in the number of average weekly hours worked for January. This is a leading indicator, so if it does not bounce back soon enough, the headline NFP number should continue to be on the weaker side.

GDP, Durable Goods and the Correction

Good Q4 GDP report with the consumption of Durable Goods still at respectable levels of growth but slowing down. In fact the annual rate of growth for December is significantly lower than the quarterly average. The behavior during the previous expansion suggests rates of growth will slowdown further.

Meanwhile, the stock market seems to have started an intermediate term correction (7-10%). The tapering is finally weighing in. Longer term support is at 1700 SPX:

Retail Sales, CPI and the Taper

Real retail sales kept growing at a good pace in Q4, while the available data on Durable Goods (October and November) suggests a slight slowdown but still a healthy pace. No wonder y/y growth in GDP is accelerating.

Meanwhile the slowdown in Core CPI has stopped but no clear turn to the upside is visible yet.

With economic activity still strong and CPI seemingly stabilizing, the Fed can still find excuses to continue tapering.

Employment - further slowdown expected

Further slowdown expected for the pace of growth in employment.

New Orders Index- strong but peaking

I have written already about the fact that the New Orders Index (component of the ISM PMI) is at peak levels but this time I wanted to show it another way, plotted as a quarterly 3-month average against the GDP. I am planning to show similar charts for other important economic indicators in the future.The red bar in the chart is based on an estimate for Q4 GDP.

So, it is peaking but this does not mean much for the economic expansion. Even lower levels still represent growth.

On the other hand, peaking also means strong and the stock market and the dollar will anticipate the continuation of tapering. This means a larger correction for the S&P500 soon.

To Taper or Not to Taper

I think it's time for an ACH (click for an introduction to ACH) on the much discussed tapering issue, more so, as it looks likely to be announced at the December 17-18 meeting (by tapering I also mean the communication that precedes the actual slowdown in QE).

So the hypotheses are:

H1 - the Fed will taper at the December meeting;
H2 - the Fed will not taper at the December meeting.

Here is a matrix with a score measuringmy judgement on how much each piece of evidence invalidates each hypothesis.


                             Evidence                                                       H1                     H2
---------------------------------------------------------------------------------------------------------------------------------
E1 - the economic indicators have been strong lately
and the Fed wanted to start tapering in September                       +                      -0.75

E2 - the latest GDP report has been strong but only
due to rising inventory                                                                -0.25                    +

E3 - the Fed has not started to communicate its
possible tapering intentions yet                                                   -0.75                   +

E4 - a slowdown in Q4 is expected                                             -0.25                    +

E5 - Bernanke could take upon himself the responsibility
to announce the taper                                                                    +                   -0.5

E6 - the December meeting is followed by a press
conference, a good opportunity to start tapering                              +                   -0.75
communication

E7 - the stock market has risen and the bond market
was flat after the strong NFP report, which could                            +                    -0.5
encourage the officials to start tapering sooner

E9 - inflation is still trending lower                                                -0.5                    +

E10 - the 7% unemployment threshold, which
has been mentioned by Bernanke early 2013, has                           +                     -0.5
been reached        
---------------------------------------------------------------------------------------------------------------------------------
                                                            Total                              -1.75               -3.00


Conclusion:

H1 is less invalidated, so it wins. The mechanical conclusion of the analysis is that the Fed will start at least communicating the taper at the next meeting.

What should be seen if, indeed, the Fed were to taper? I would guess that some early signaling by Fed officials (today there are three such speeches) but also the markets could anticipate such a decision somehow - the markets were not taken by surprise in September when tapering was postponed even if everybody was ready for it to happen.

Lastly, the conclusion of this analysis is not to be taken for granted. This framework is more of a way to put arguments in order and to see the pivotal ones. Expressing conviction in probabilities is much better. In this case, I would say there is a 60% chance for the Fed to start at least communicating the tapering.

Intermediate Term Top

Here is a chart of the weekly S&P 500.

I measured all the bull uplegs and the intermediate term corrections. Generally, twenty-and-something percent uplegs are followed by shorter ones. Measuring from the June low, the latest bull leg has already been 16% long, so, since the market is up against the 1800 resistance, and already committed above it, I think a drop has to happen very soon. The following correction would be somewhere between 7 and 10 % long.

New Orders Index

"Anyone who has studied markets half-seriously learns not to associate vigorous economic activity with stock market bottoms, but with stock market tops."

     Will Rahal.


Here is an up to date chart of the New Orders Index.

In the vein of the opening quote, it is hard to be bullish over the intermediate term given this chart. I do not think we can talk of a bull market top yet but a larger correction is not out of the question soon. Meanwhile, the short term looks good, with 1800 as next stop.

Employment

The average rate of growth in private payrolls has slowed down steadily during the last months to a level that may mark an inflection point. Any lower than this and the economic expansion is in peril, similar to 2007. We could see a bounce from here, the most likely scenario, but it could tip the Fed towards tapering early next year.

NYHL

I have talked recently about signs of a peak in the business cycle, but the stock market is ignoring them.

The chart above is that of the difference between the 52-week New Highs and the 52-week New Lows for the NYSE.

The rally in 2013 was accompanied by a huge expansion of new highs vs. lows and this is still the case on the latest surge to historic highs for the S&P500. This often signals short term capitulation, but the longer term implications are positive for the overall bull.

For me, the latest bull leg has began at the end of June, after the 7% correction, and it is up 12% as of Friday. A 16% rise, which is quite average, would take the market to 1800.