The Evolution of a Macro Stock Market Thesis
Entering 2015, things looked fine underneath the surface. We had good sector rotation among stocks in the U.S., and globally things looked good. Japan was still in a strong uptrend, coming off a nice breakout, European stocks looked good and emerging markets were stable. The only thing that annoyed me was that the S&P500 was quickly approaching the 161.8% extension of the 2007-2009 decline (near 2130) and both the Nasdaq100 and Nasdaq Composite were getting close to their all-time highs from March of 2000.
As we entered May and June of last year and our upside targets were being achieved in these major markets, we then started to break uptrend lines from their respective 2009 lows. This was not only the case in the S&P500 and Nasdaq, but in the more globally exposed NYSE Composite, the Small-cap Russell2000 and even in the Mid-caps. Japan put in a failed breakout in June last year, and the weight of the evidence suggested fading stocks. Short positions were also appropriate at the time.
In July and August, things really started to sell off hard, not just in the U.S. but globally. Japan got crushed, so did Europe, and Emerging Markets broke key support levels that had been in place for several years. The 6-month consolidation in most of the major US Stock market indexes resolved themselves to the downside. This presented the new problem of "overhead supply". When support levels in place for a long time break down, the market is suggesting that the buyers at those prices had run out and now the sellers were in control, hence the breakdown. This is why former support turns into resistance. It's what we refer to as, "polarity".
Sure enough, after the global stock market declines in August, we had a nice recovery back up towards that overhead supply over the next few months. In late October early November, the selling resumed. I saw no reason to be bullish of stocks. The list of stocks on the NYSE making new lows was expanding. The list of countries around the world hitting new lows was growing. The amount of sectors in the US hitting new lows was also increasing. What appeared to be a more structural decline for stocks as an asset class was taking shape nicely.
Coming into the new year, 2016, we obviously wanted to be erring on the short side, whether in U.S. Stocks, Financials as a sector, emerging markets, etc. On or around January 20th, over 90% of our downside targets had been achieved across the board. At those new lows in price, momentum on both daily and weekly timeframes in a lot of cases, was diverging positively. In other words, with lower lows in price into January 20th, momentum was putting in higher lows all over the place, particularly in emerging markets. From any kind of tactical or intermediate-term perspective, there was no reason to be short any longer.
Over the next week, it became very clear that erring on the long side of stocks was our best approach moving forward, regardless of my longer-term views. Prior to this key January 20th date, I had downside targets in the S&P500 under 1600 potentially. I was extremely bearish bigger picture and for good reason. Breadth deterioration continued and the trends across the board were well defined with lower lows and lower highs. Tactically, however, I thought there was a nice mean reversion opportunity, especially in emerging markets and even more so within Latin America.
By the time late March / early April came around, the mean reversions we were hoping for had already taken shape. It wasn't until mid-February that the more developed markets put in their bottoms, like the U.S., Japan and Europe. Meanwhile Emerging markets were exploding, in some cases up 30-40% in some individual countries in Latin America. The entire base metal/mining complex had bottomed, and a lot of these EM nations have exposure in that space. These are the ones who benefited the most.
By this point, my dilemma was clear: Structurally, I was still bearish. I had to be based on the weight of the evidence. But tactically, neutral was a much better approach. As we got into May, bullish stocks was still not on my radar from any sort of time horizon, short-term or long-term. Neutral was a much better approach, with a bias towards the short side of stocks, particularly European and U.S. financials and Japanese equities with Yen rallying. Again, I saw no reason to be bullish of stocks. Neutral to bearish seemed most appropriate and therefore my longer-term downside targets remained intact. Why not?
Over the past 2 months, all of those monster rallies off the January/February lows were able to consolidate and digest their gains. Based on the weight-of-the-evidence, a rollover in many U.S. indexes and sectors seemed like the higher probability outcome based on European Banks continuing their crash, Japanese stocks continuing to make new lows, Japanese Yen (the safest of all havens) kept strengthening, and interest rates, both U.S. and abroad could not find a bottom.
As we entered July, the selling in Europe and Japan continued, but the improvements in Emerging Markets that began in January kept progressing. Multi-month consolidations in Latin America were resolving to the upside. There was no reason to be short the emerging space. Meanwhile, the largest of large-cap stocks in the U.S. refused to sell-off. A smart mentor of mine once taught me, "JC if you're shorts aren't working, the market is suggesting it is in a stronger environment than you think". This was very clear as we came into early July. Although I kept emphasizing large cash holdings in our portfolios, even into July, I still wanted to err on the bearish side and I set specific parameters for short positions. For example, if we were below 2080 in the S&P500, shorts were warranted. If we were above that, then neutral was a better approach. But the amount of these clean risk/reward scenarios from the short side were shrinking by the day. A more neutral position therefore seemed most appropriate. I was extremely bullish of cash, as I had been since early May.
Over the past few weeks, we have seen even more breakouts, not just in emerging markets. Both the S&P500 and Dow Jones Industrial Average have broken out to new all-time highs, pushing through over a year of overhead supply. More importantly, the breadth has improved dramatically. The list of stocks on the NYSE making new 52-week highs is an fresh multi-year highs. The stocks-only NYSE Advance/Decline line went on to make new all-time highs. Individual sectors, the most important ones, are approaching or breaking out to fresh highs: Technology, Consumer Discretionaries and Industrials are all leading the way higher.
Interest rates bottomed out. The U.S. 10-year yield put in a failed breakdown below recent lows and momentum diverged positively. I think we get back up towards 2% on 10s. This is happening as U.S. Treasury Bonds are showing some of the most bullish sentiment that we've ever seen and prices have all reached and, in some cases, exceeded our upside targets. When you ask, what is the catalyst to take stocks higher? There's a lot of money that appears to be exiting the bond market.
With higher rates, the crashing European banks have stabilized. In the U.S. we are seeing bullish momentum divergences in Financials relative to the S&P500. When financials are leading, it's not a bad thing. In Japan we're seeing the same thing. Finally a stabilized stock market that isn't crashing to new lows every day. More importantly, the strong yen has finally reversed course. USD/JPY has been rallying and I think has legs up towards 112. That's not bearish for stocks.
I pride myself in keeping an open mind. I put in a lot of work to put the puzzle together. Based on the weight-of-the-evidence that we have today, it is awfully difficult to be bearish of stocks. We've been erring on the long side and we continue to want to approach the market in that way.
For a list of stocks, ETFs and commodities that we've wanted to be buying this month, join us in a more official capacity here.