The Nasdaq 100 broke through resistance at 7000. Expect retracement to test the new support level but respect is likely and would signal a primary advance with a target of 7700.
The S&P 500 respected support at 2700. Follow-through above 2750 would signal another test of 2850.
Volatility is falling and a dip below 1.0% would suggest that the market has returned to business as usual.
Now that 93% of S&P 500 stocks have reported first quarter earnings we can look at price-earnings valuation with a fair degree of confidence. My favorite is what I call PEMax, which compares Price to Maximum Annual Earnings for current and past years. This removes distortions caused by periods when earnings fall faster than price, by focusing on earnings potential rather than necessarily the most recent earnings performance.
Valuations are still high, but PEMax has pulled back to 22.78 from 24.16 in the last quarter. Valuations remain at their highest over the last 100 years at any time other than during the Dotcom bubble. Even during the 1929 Wall Street crash (Black Friday) and Black Monday of October 1987, PEMax was below 20.
While that warns us to be cautious, as valuations are high, it does not warn of an imminent down-turn. Markets react more to earnings than to prices as the chart below illustrates.
The last two market down-turns were both precipitated by falling earnings — the blue columns on the above chart — rather than valuations.
While it is concerning that prices have run ahead of EPS — as they did during the late 1990s — consolidation over the past quarter should allow earnings room to catch up.
The S&P 500 has broken out above its symmetrical triangle and we are now witnessing retracement to test the new support level at 2700. Volatility is falling and a dip below 1.0% would suggest that the market has returned to business as usual.
Twiggs Money Flow remains a respectable distance above the zero line and is flattening out. Breach of primary support at 2550 seems unlikely.
It was clear from investment managers’ comments at the start of the year — even Jeremy Grantham’s meltup — that most expected a rally followed by an adjustment later in the year or early next year.
Valuations are high and the focus has started to swing away from making further gains and towards protecting existing profits. The size of this week’s candles reflect the extent of the panic as gains patiently accumulated over several months evaporated in a matter of days.
Volatility spiked, with the VIX jumping from record lows to above the red line at 30.
VIX reflects the short-term, emotional reaction to events in the market but tends to be unreliable as an indicator of long-term sentiment. I prefer my own Volatility indicator which highlights the gradual change in market outlook. The chart below shows how Volatility rose gradually from mid-2007, exceeding 2% by early 2008 then settled in an elevated range above 1% until the collapse of Lehman Bros sparked panic.
The emerging market crisis of 1998 shows a similar pattern. An elevated range in 1997 as the currency crisis grew was followed by a brief spike above 2% before another long, elevated range and then another larger spike with the Russian default.
The key is not to wait for Volatility to spike above 2%. By then it is normally too late. An alternative strategy would be to scale back positions when the market remains in an elevated range, between 1% and 2%, over several months. Many traders would argue that this is too early. But the signal does indicate elevated market risk and I am reasonably certain that investors with large positions would prefer to exit too early rather than too late.
So where are we now?
Volatility on the S&P 500 spiked up after an extended period below 1%. If Volatility retreats below 1% then the extended period of low market risk is likely to continue. If not, it will warn that market risk is elevated. Should that continue for more than a few weeks I would consider it time to start scaling back positions.
Only if we see a further spike above 2% would I act with any urgency.
Cross-posted from Goldstocksforex.com:
What caused the Black Monday crash of 1987? Analysts are often unable to identify a single trigger or cause.
Sniper points to a sharp run-up in short-term interest rates in the 3 months prior to the crash.
Valuations were also at extreme readings, with PEmax (price-earnings based on the highest earnings to-date) near 20, close to its Black Friday high from the crash of 1929.
Often overlooked is the fact that the S&P 500 was testing resistance at its previous highs between 700 and 750 from the 1960s and 70s (chart from macrotrends).
A combination of these three factors may have been sufficient to tip the market into a dramatic reversal.
Are we facing a similar threat today?
Short-term rates are rising but at 40 basis points over the last 4 months, compared to 170 bp in 1987, there is not much cause for concern.
PEmax, however, is now at a precipitous 26.8, second only to the Dotcom bubble of 1999/2000 and way above its October 1987 reading.
While the index is in blue sky territory, with no resistance in sight, there is an important psychological barrier ahead at 3000.
Conclusion: This does not look like a repetition of 1987. But investors who ignore the extreme valuation warning may be surprised at how fast the market can reverse (as in 1987) from such extremes.
July labor stats are out and shows the jobless rate fell to a 16-year low at 4.3%. Unemployment below the long-term natural rate suggests the economy is close to capacity and inflationary pressures should be building.
Source: St Louis Fed, BLS
But hourly wage rates are growing at a modest pace, easing pressure on the Fed to raise interest rates.
Source: St Louis Fed, BLS
Fed monetary policy remains accommodative, with the monetary base (net of excess reserves) growing at a robust 7.5% a year.
Source: St Louis Fed, FRB
Our forward estimate of real GDP — Nonfarm Payroll * Average Weekly Hours — continues at a slow but steady annual pace of 1.79%.
Source: St Louis Fed, BLS & BEA
The Nasdaq 100 has run into resistance at 6000. No doubt readers noticed Amazon [AMZN] and Alphabet [GOOG] both retreated after reaching the $1000 mark. This is natural. Correction back to the rising trendline would take some of the heat out of the market and provide a solid base for further gains. Selling pressure, reflected by declining peaks on Twiggs Money Flow, appears secondary.
The S&P 500 is also running into resistance, below 2500. Bearish divergence on Twiggs Money Flow warns of moderate selling pressure but this again seems to be secondary — in line with a correction rather than a reversal.
Target 2400 + ( 2400 – 2300 ) = 2500
GDP results for the second quarter of 2017 reflect recovery from the soft patch in 2016.
Source: St Louis Fed, BLS & BEA
Nominal GDP for Q2 improved to 3.71%, measured annually. This closely follows our intial estimate calculated from Nonfarm Payroll * Average Weekly Hours * Average Hourly Rate.
Real GDP, after adjustment for inflation, also improved, to a 2.1% annual rate.
Source: St Louis Fed, BLS & BEA
Bellwether transport stock Fedex is undergoing a correction at present but selling pressure appears moderate. Respect of medium-term support at 200 is likely and would confirm the primary up-trend (and rising economic activity).
The Nasdaq 100 gained more than 20% year-to-date, from 4863 at end of December 2016 to 5908 on July 28th. Growth since 2009 has been consistent at around 20% a year but now appears to be accelerating. To my mind that warns sentiment may be running ahead of earnings, increasing the risk of a major adjustment. But there is no indication of this at present.
The S&P 500 continues its advance towards 2500 at a more modest pace. Bearish divergence on Twiggs Money Flow warns of selling pressure but this seems to be secondary in nature, with the indicator holding well above zero.
Target 2400 + ( 2400 – 2300 ) = 2500
The CBOE Volatility Index (VIX) made a new low of 9.30 indicating record low levels of stock volatility. High levels of stock buybacks and large ETF fund inflows may both have contributed, but this is only the third time in its 27-year history that index has broken below 10%. The first was in late 1993. The second, in late 2006, was followed a year later by a massive market snap-back. This time is no different. Volatility is unlikely to remain at such low levels and eventually we will see a market down-turn, accompanied by high volatility, but there is no crystal ball that can tell us whether this will be in one year or five.
Corporate bond spreads are also falling, with the spread between lowest investment grade Baa (10-year) and equivalent Treasury yields at their lowest point since 2008.
Source: St Louis Fed & Moody’s
The yield curve is flattening but remains comfortably above a flat or negative yield curve when
the yield differential (10-year minus 3-month yields) falls below zero. A negative yield curve is a reliable warning of recession within 12 months.
Source: St Louis Fed
The Freight Transportation Services Index displays a steady increase in economic activity.
Source: St Louis Fed & US Bureau of the Census
And the S&P 500 continues its advance towards 2500.
Target 2400 + ( 2400 – 2300 )
Retail sales growth (excluding motor vehicles and parts) slowed to 2.4% over the 12 months to June 2017.
Source: St Louis Fed & US Bureau of the Census
Seasonally adjusted light vehicle sales are also slowing.
Source: St Louis Fed & BEA
Seasonally adjusted private housing starts and new building permits are starting to lose momentum.
Source: St Louis Fed & US Bureau of the Census
The good news is that Manufacturer’s Durable Goods Orders (seasonally adjusted and ex Defense & Aircraft) are recovering.
Source: St Louis Fed & US Bureau of the Census
Cement and concrete production continues to trend upwards.
Source: US Fed
And estimated weekly hours worked (total nonfarm payroll * average weekly hours) is growing steadily.
Source: St Louis Fed & BLS
All of which suggest that business confidence is growing and consumer confidence is likely to follow. Bellwether transport stock Fedex advanced to 220, signaling rising economic activity in the broader economy.
Target: 180 + ( 180 – 120 ) = 240
The S&P 500 broke resistance at 2450, making a new high. Narrow consolidations and shallow corrections all signal investor confidence typical of the latter stages of a bull market. The immediate target is 2500* but further gains are likely.
Target: 2400 + ( 2400 – 2300 ) = 2500
The stock market remains an exceptionally efficient mechanism for the transfer of wealth from the impatient to the patient.
~ Warren Buffett
The S&P 500 is experiencing warns of medium-term selling pressure, signaled by bearish divergence on Twiggs Money Flow. The last correction was shallow, typical of stage III in a bull market, and this one is likely to be too. Respect of support at 2400 would signal another primary advance. A correction to test primary support at 2300 is unlikely, but would warn that investors are jumpy and taking profits. This would signal stage III is closer to a top.
