Looking For The "Throttle-Up" Trade

The carnage in October was brutal and got us reevaluating our longer-term market view. The S&P 500 dropped almost 7% for the month. The hardest hit was the Nasdaq and the Russell 2000 down 9% and 11%, respectively.

We had decided to fade the rally starting in mid-August for several reasons (see Seven Reasons to Fade This Rally and The “Low Energy” Rally). As a result, our portfolio held up fairly well only down 4.5% for the month. Not great – but not terrible. We had the call right but miscalculated our execution in the core portfolio.

We ended up taking a small long position near the 2780 level based on the Fibonacci sequence (Near-Term Trading Strategy) which proved a bit early but caused minimal damage in the end.

The recent bounce is nice to see but we are not getting aggressively long just yet. The technical damage has been severe and we are just now approaching the 20-day and 200-day SMA which may act as resistance. We’ll need to see a nice follow-through and additional evidence that the onslaught is over. We’re still on the sidelines waiting.

What we don’t like is the possibility that the 200-day SMA for the S&P 500, which has acted as support in the past is now acting as resistance. Even though we did receive a bullish MACD cross on the daily chart, we’d like to see a follow-through thrust before entering the market aggressively to the long side.

In Stockcharts.com, “In the Weekly Wrap I have been saying that a short-term buy of SPY should not be considered until the daily PMO turns up. As it happens, the PMO turned up on Thursday, but I must confess that I wasn't thrilled. When the Price Momentum Oscillator (PMO) turns up, we should view it as a possible short-term BUY signal; however, there are plenty of caveats to that statement. For one thing, we want to see the PMO make a smooth bottom after a nice, smooth decline. I have highlighted two of what I consider to be the best looking PMO bottoms on the chart. The problem with the most recent one is that the corresponding price bottom presents as a sharp "V" compared to the more gradual, rounded price bottom in June/July. Bottom line is that the July PMO bottom came a day before the price breakout, whereas the most recent PMO bottom didn't materialize until after the price breakout. Not to mention the problems with the rising trend line, that has now become resistance. I will err on the side of caution and say that the current setup is less than ideal. Pass.”

From Sentiment Trader, “Buying interest hasn’t been very broad the past 3 days with no breadth thrust.”

“Even though the S&P 500 has rallied 1% for 3 days straight, and that has been a good sign, the best sustained bottoms have come when investors have shown more eager interest.”

Sentiment Readings

The following chart is the CBOE equity put/call ratio. Levels are certainly elevated, but like the sell-off earlier in the year, there hasn’t been excessive panic. The 10-day SMA near 0.78 would be considered a panicked market in our opinion.

When you view the CBOE equity put/call 10-day SMA over a longer time frame, we can see the 0.78 level as an extreme and a buying opportunity. The latest sell-off barely moved the needle. The drop and recovery were too quick.

When you look at the AAII Investor Sentiment data, the sell-off wasn’t accompanied by a major move lower in the 10-day SMA Bull/Bear ratio. When investors get overly bearish, it’s usually a sign of panic and capitulation. A drop to 0.73 (or one standard deviations from the 200-day mean) in the ratio is the current panic level.

Going back on a longer time scale, the minus one standard deviation level for the 10-day SMA of the Bull/Bear Ratio has offered fairly decent buy points.

The NAAIM Exposure Index provides insight into the actual adjustments active risk managers have made to client accounts over the fast few weeks. This index signals a high level of panic when the index falls below one standard deviation from the 200-day SMA. Looking at the next chart shows panic levels were not met during the market sell-off last month.

The Sabrient Insider Sentiment Index is an equal- dollar weighted index comprising publicly-traded companies that reflect positive sentiment among those 'insiders' closest to a company's financials & business prospects (top mgt, directors, analysts). We watch the year-over-year moves in this index. We noted a few months back that we were seeing a bearish divergence between the annual rate of change in the SISI and the S&P 500. That turned out to be a timely signal. Usually the market exhibits extreme panic when the year-over-year change in the SISI drops below 10%. It currently sits near 2%. There is still more downside to come if this index were to flash a buy signal due to excessive panic.

In a recent report out of Bloomberg they note, “For the third week in a row, individual investors bought stocks while institutional and hedge funds were net sellers, data on client flows compiled by Bank of America showed. Thanks to retail demand, equity buying by all the firm’s clients rose last week to the highest level since late May.

While a reflection of only one firm’s clients, the data is the latest to show the divided sentiment that has gripped the market in recent months. To some, the latest selloff is another dip that’s worth buying with earnings growth running at 20 percent and valuations falling. The others see a congregation of forces that threatens to slow the 9 1/2-year bull market: higher bond yields, slowing profit growth, and persistent political tensions at home and abroad.”

This ties in with what we have seen in the various sentiment indicators that we watch. While a bottoming in these sentiment indicators is not as mandatory phenomenon to mark a bottom, it would have been more comforting to see the proverbial “blood in the streets” scenario than the BTFD reaction.

“Amid the losses, bulls were unbowed. BofA’s private clients snapped up more than $1 billion of stocks last week, the most since February and the sixth-largest in data going back to 2009.

The buying spree followed a month when individuals went almost all in on stocks. In September, cash as a percentage of assets among Charles Schwab Corp. clients fell to 10.3 percent, the lowest since at least 2004. At TD Ameritrade Holding Corp., client activity jumped last quarter, with average trades per day on the brokerage site surging 50 percent over the past year to 795,000.”

What’s more, is that it seems to be the same popular names that are being bought. In another Bloomberg piece, “Real-time information on this phenomenon is scarce, but going by data from Morgan Stanley’s brokerage unit for institutions, crowdedness has yet to ease back to its historic average. As of last Friday, the 50 most popular stocks made up 32 percent of long positions among hedge fund clients. While that’s down from a peak of 35 percent in August, it’s still above 87 percent of readings since the bank began tracking the data in 2010.”

This is in spite of the most crowded stocks taking the brunt of the hit in October.

The benign nature of this sell-off can also be seen in its rather rapid time frame towards the perceived bottom. From Knowledge Leaders Capital, “Furthermore, we haven’t seen enough volatile down days indicative of across the board liquidation that is seen at good lows. The number of days over the last 6 months in which global stocks have finished down by 2% or more only stands at 3. Each good low over the last fifteen years has seen this number breach at least 9.”

“Next, the net number of stocks making new 200-day highs (number making new highs minus the number making new lows) isn’t extreme enough either. We did breach the 20% threshold earlier in October, but this indicator needs to approach 40% to mark a good, durable low.”

Research from Sentiment Trader shows, “The decline has created a wide spread between Smart and Dumb Money sentiment. The former is above 70%, the latter below 20%.”

“When it has been this far between the two, stocks rallied every time during the next 1-3 months. What’s especially notable about that record is that there was no bull market filter. The dates included bear market environments, but when sentiment was this stretched, stocks rebounded, even if they were going to ultimately roll over to lower lows.” {Emphasis added}

Seasonality on Our Side

The chart from Topdown Charts shows that the rally off the typical October weakness is a profitable opportunity.

“First chart shows the S&P500 against its historical seasonal pattern across the period 1990-2017. You can see that the correction came perhaps slightly overdue from a seasonal standpoint, but likewise you can see that it's about this time of the year where things pickup again - strictly going off the historical averages.”

Given that we are also in a mid-term election year, that bodes well for a market rebound from here. According to Almanac Trader, “This past midterm-year October that ended yesterday finished well below expectations and historical averages. DJIA declined 5.1%, S&P 500 dropped 6.9% and NASDAQ was off 9.2%. October’s losses were the seventh worst decline for DJIA since 1950, fourth worst for S&P 500 and fifth worst for NASDAQ since 1971.

Historically, November and December market performance did hold up following a negative October.

In the {below} table every down October for DJIA, S&P 500 and NASDAQ have been compiled along with their respective performance in November and December. Compared to all Octobers, DJIA and S&P 500 performance improved in November and December when October suffered a decline. DJIA’s average performance in November and December after an October decline improved to 2.3% and 1.9% compared to average gains of 1.6% and 1.7% respectively in all years. S&P 500 in November had a modestly weaker average performance following a down October, but December was notably stronger. NASDAQ’s November performance after an October decline is worse than average, but the results are heavily skewed by double-digit declines in 1973, 2000 and 2008.

Even better and perhaps of greater relevance is the performance of November and December in past midterm years where October was down (shaded in grey and italics in table). All midterm Novembers and Decembers were positive and average performance was nearly double or better.”

Year-End Opportunity to “Throttle-Up”

According to Jason Goepfert from Sentiment Trader, “Due to a rapid increase in defensive strategies, the Equity Hedging Index has soared into extreme territory after last week’s drop. Readings this high since 1999 have consistently led to positive two-month forward returns, even during bear markets.”

In another observation out of Sentiment Trader, “Traders who tend to buy into declining prices spotted an opportunity over the past week. Hedgers in the major equity index futures contracts covered nearly $19 billion of their short position, one of the largest one-week changes ever. That has preceded good returns for stocks.”

“Investors who tend to sell into declining prices also spotted an opportunity to reduce their risk. Equity funds saw an outflow of more than $17 billion in the past week alone, one of the largest we’ve seen in years. Such large one-week flows led to excellent returns for stocks. The different between these two sets of flows was nearly the largest in a decade, all prior ones leading to a rally for the S&P 500.”

Waiting to see how the Mid-Term Elections Play Out

We may see a surprising “blue wave” this week. Drawing from the brilliant work from Cam Hui of Humble Student of the Markets, he notes that early voting within swing states is much higher than normal and that millennial turnout is tracking much higher than normal. Millennial's tend to lean democratic according to Pew Research Center (via Humble Student of the Markets).

Our sentiment indicators have not flashed extreme panic from the October sell-off. We would like to see a market bottoming process with sentiment confirmation. We haven’t redeployed capital as we believe the downside momentum has not run its course yet. While a wash-out in the sentiment indicators isn’t a precursor to us deploying additional capital, it makes us a bit more patient. We are waiting for a reconfirmation “thrust” and the Mid-Term Election results before moving back in aggressively.

We believe the final two months will offer a trading opportunity but we are uncertain that the S&P 500 will reach new highs. We have grown increasingly cautious over the longer-term. We’ll be updating our strategic long-term focus in the days to come as 3Q earnings season wraps-up and the Mid-Term Elections conclude.

Joseph S. Kalinowski, CFA