Rally or Rebalance?

As we end our first full week of market activity in 2013, most equities markets around the globe have rallied to near 52 week highs. Considering all the news and attention, it is just a little surprising that the S&P 500 only went up 0.38% for the week ending 11 January 2013. There are many ways to view this market rally, which like all rallies is unlikely to continue without some decline. It helps to look at bond market activity, some currency movement, and several indexes that monitor market activity, all of which give us correlation or confirmation of market direction. Trying to find the top of any rally, just like trying to find the bottom, is more luck than information gathering. The best we can hope to accomplish is buying near low points, and selling close to high points. When evaluating individual shares of companies, some tend to go up more than the overall market, while some fall much further during a correction. In general large cap companies tend to follow the market, while small and mid cap companies tend to overshoot and undershoot. The other common factors every January are fund positioning and the start of another round of quarterly earnings reports. Many hedge fund and mutual fund managers start off the new year buying shares of companies that make up the parts of mutual funds, Electronically Traded Funds (ETF), and hedge funds. This creates a supply and demand for shares of larger companies, with demand often driving share prices higher. Fitch Ratings noted that Money Market Funds recently increased their holdings in European Banks by 8% for the fifth straight month. On a calendar basis, Alcoa (AA) often starts off each quarterly round of earnings season. On 8 January Alcoa reported earnings of 0.06¢ per share (in-line with expectations) and revenues higher than expectations. Forward guidance was positive, including a long term outlook towards 2020. Despite initial positive reaction, within a couple days shares of Alcoa were back near where they started, and the results on the company had little sway on the markets. Earnings reports from several other companies , such as banking giant JPMorgan (JPM) near 16 January, are likely to have more of an effect on the direction of the overall market.
There are several indicators that we can watch each day, or each week, that give us an idea of the state of stock markets. Often investors look at overbought and oversold indicators, which can be important to watch, but do not tell us all we need to know for the long term. On a daily basis we can watch the Arms Index to see if unusually heavy buying or selling is taking place. Where the Arms Index (TRIN) is more valuable than individual share overbought or oversold indicators, is that it factors in the upside and downside volumes of the entire New York Stock Exchange. When TRIN is less than 1.0, then buying activity to the upside is heavy, while when TRIN is higher than 1.0 selling activity is increasing. One additional use I have for the TRIN is when it spikes high, because that can be an indicator of panic selling, and sometimes that can be a good time to pick up shares of a company at a short term low point. However, if our investments tend to be longer term holdings, then we need a better long term trend indicator, which we see in the chart above called SPXA50R. This index is a measure of the percentage of stocks on the S&P 500 which are above their 50 day moving average (50dma). I have included the longer multi-year chart to show that SPXA50R rarely stays above the high 80s for long. That can be a great indicator for us to look at our holdings and see if we want to take some profits. Our example of how to use this for market bottoms is in August 2011 at 0.4000 and May 2012 at 13.80000. The event that caused a market sell-off in August 2011 was the first debt ceiling stand-off in Congress, and the downgrade to AA by S&P Ratings. Our late May 2012 bottom is a more recent example, but if you bought shares at some point then you are very likely to have seen a nice gain near early September, or you may have seen a nice gain early 2013. This is also a great indicator for people who do not have the time to check the markets often, since individual shares can continue to gain a little after a peak in SPXA50R. It also helps to watch Volatility in the markets and VIX is very useful indication of the perception of risk in the markets. Currently we have a very low Volatility Index (VIX) reading, which some consider a sign of complacency in the markets. Of these three indicators, using SPXA50R for making decisions on when to buy, sell, or rebalance your investments can be the most useful for long term investors.
The biggest chatter in market news this past week has been about the Great Rotation into stocks. In times like this it can be tempting to think that you have missed the market, but it is better to be patient and not follow a hasty reaction. The inflows of funds into stocks are impressive when measured against the past couple years of January data, but compared to the massive outlfows in 2008 and 2009 the recent flow of funds is not significant. On a practical measure of various economic conditions, we still find slow growth in the United States, most of Europe in recession, emerging markets slowing, and even China resorting to stimulus spending on infrastructure. We really need several weeks of strong inflows before we can consider this a solid trend or rally. The roughly $22 billion that has flowed into equities since the beginning of January is the highest amount since September 2007, though emerging and world markets accounted for more of these moves than did US stock markets. Despite the rotation out of safe haven bond investments and into equities, several analysts are warning of a correction in the near future. Ahead of Fiscal Cliff negotiations, and worries about changes to the tax codes in the US, some investors booked profits in December; some of those investors may now be trying to get back into the market. Recent economic data has been somewhat ignored by investors, especially the not so great figures on the US Trade Deficit, hitting $48.7 billion in November 2012 against an expectation of $41.3 billion. Exports and Imports did increase in November, which is slightly positive for the US and Global markets. Automotive Sales increased sharply in November. Manufacturing data in the US, researched through the Philadelphia Federal Reserve, saw more downward revisions for 2012 than upwards. The US Budget Deficit fell to a very low $260 million in December 2012, which is the lowest since December 2007. Jobless Claims came in at 371000 against an expectation of 36500, with the prior figures revised downwards to 367000. Market Analyst Tom DeMark, advisor to SAC Capital, Soros Funds, Omega Advisors, and others, expects a high in the S&P 500 near 1500, to be followed by a fall of at least 5.5% in the near future. Quite simply he expects buyers to run out as we near the psychological barrier of 1500 on the S&P Index.
In commodities we find that Iron Ore prices has climbed recently, mostly in speculation of a new ruling group in China ushering in new infrastructure spending in the near future. Given this spike in Iron Ore, some analysts do not see these price levels as sustainable. We can see some of the affects of this in the recent rise in the Australian Dollar (AUD) relative to other currencies. Often commodity currencies are considered as risk currencies, since they are tied to global growth and construction spending. So we get some correlation of stock market gains when we see the Australian Dollar increasing relative to the US Dollar (AUD/USD). If we see a continued decline in the AUD/USD pair, then we usually find a decrease in stock markets, though sometimes the currency decline happens prior to a market decline. Brazil is another large exporter of Iron Ore, mostly through global mining giant Vale (VALE). While the Brazilian Real is not heavily traded on Forex (Foreign Exchange) markets, we can watch the share price action in Vale for another indicator on changes in sentiment towards raw materials investments.
Perhaps the largest recent change, which I mentioned a few times in prior articles, is a relaxing of Basel III rules ahead of the 2018 compliance deadline. The Basel Committee on Banking Supervision recently published a revised set of rules for bank liquidity. Global banks will need to meet 60% of the rules by 2015, and follow full implementation in 2019, instead of 2018. Banks in the UK and Switzerland are thought to be slightly ahead or in line with Basel III rulesimplementation, with US banks not far behind, though European banks are not faring as well. The major change in the newest rules is that some equities can be used for collateral, including AA or greater Mortgage Backed Securities (MBS). One of the largest expansions in the new rules is the allowance of lower rated bonds as collateral, though obviously a haircut (valuation reduction) is applied. Large banks with cash positions may find some bonds more attractive for yield, especially with the European Central Bank and the Federal Reserve buying sovereign bonds on the open secondary markets. Where we can see the effects of this is through watching the 10 year US Treasury and the 30 year US Treasury. The 10 year note is the most issued, though the 30 year is a good correlation for moves on the 10 year Treasury. Under normal (historical) markets, we often find a rotation out of bonds and into stocks, which should drive yields in bonds higher. Yield moves inverse to bond prices on the secondary market. While the yield on the 10 year and 30 year notes has climbed recently, both are still at relatively low yield levels. A recent auction of new 30 year US Treasuries saw solid demand, indicating that the demand for safe haven bonds is still somewhat high. As long as we see continued strong demand for Treasuries, it is tough to consider the recent stock markets rally as a strong and continuing trend.
In bizarre market news, we find mention of a Trillion Dollar Platinum coin being mentioned as a way around upcoming Debt Ceiling negotiations. While in theory it would work to avoid the Debt Ceiling, and oddly enough would be completely legal, such an act might spook global investors, who may question the credit worthiness of the United States. We are likely to see a battle on the Debt Ceiling, and we may get a repeat of the sell-off that happened in August 2011 during similar negotiations. Ultimately I think we can expect politicians to avoid playing with the credit worthiness of the United States, though we can reasonably expect them take discussions right up to the deadline. if this talk of Trillion Dollar platinum coins is not odd enough, you might find some odd amusement in this article about gold valuations in the mythical land of Hobbits, Elves, Orcs, and Men called theMacroeconomics of Middle Earth. Here on the real earth we find that North Korea has been seeking advice from Germany on attracting international investors. While this would be a positive development for global markets, it seems investors are still taking a wait and see approach to this news. Across the globe we find rumours of Hugo Chavez of Venezuela possibly dead or in a coma, yet demand for Venezuelan Debt has recently soared. The market does not seem to be pricing in a demise of Hugo Chavez, possibly because China continues to invest in Venezuela.
In housing news, we find recent talks of a settlement over mortgage irregularities with ten US banks. The final settlement amount is $8.5 billion, with $3.3 billion expected to go to former homeowners, and $5.2 billion slated for mortgage modifications. Fitch Ratings expect stable demand for Mortgage Backed Securities (MBS) to continue throughout 2013, which is positive for continued improvements in the US housing markets. Fitch also note a change in servicing of commercial mortgages (CMBS) following downgrades, which is another trend they expect to continue. On another positive note for Commercial Mortgage Backed Securities (CMBS), Fitch Rating note a decline in delinquencies to under 8% at the close of 2012. So while we might not be entirely sure where and when stock and bond markets may go, we can reasonably expect continued investments in housing to push along a recovery in the housing sector. Patience and carefully watching market indicators can reward long term investors. Here is wishing all of you a happy and prosperous 2013.
G. Moat
Disclosure: I hold a long positions in Alcoa (AA) and Vale (VALE). This article is not a recommendation for investors to either buy, nor to sell, shares in Alcoa nor Vale. Investors are advised to perform their own research prior to making investment decisions.