Since the March 2009 low in the S&P 500, the index has appreciated by more than 150%.  Since April 18 through the intraday high on Wednesday, the S&P 500 was up 10%.  After review of the FOMC minutes, investors began to fear Federal Reserve quantitative easing ($85 billion per month) could begin to taper back as soon as June.  The S&P fell late Wednesday by about a percent and selling continued through the end of the week.  Overseas, manufacturing reports from China (the HSBC Flash PMI) showed contraction for the first time in seven months and manufacturing in Europe has been persistently in a contraction phase.  The Nikkei dropped by 7.3% on Wednesday night.

Two questions arise when the market pulls back:

1) is the pull back just a correction of short term overbought conditions?, or

2) was the entire rally since the low of 2009 created by Federal Reserve monetary policy and when the expansionary quantitative easing ends, should we expect the stock market to re-enter a secular bear period?

2013-05-28-A

There is no question that the answer to question one is “yes”.  Investors generally like slow and steady and the one month 10% advance was beginning to make even bullish investors nervous.  Massive quantitative easing is already priced into the market so any doubt about the continuation of QE Infinity is likely to cause some equity selling.

Fast money types like to take profits opportunistically.  These investors tend to be crowded into the high growth, high momentum stocks in the market.  From the Wednesday high and into the continuation of the sell-off on Thursday, high relative strength stocks have had a beta of about 1.4 relative to the S&P 500 versus the their normal beta of about 1.  The biggest winners are being sold which is a strong indication of fast money profit taking.

Fast money profit taking is usually a short-duration event.  One could argue that the sell-off late last week was simply traders reducing long positions in front of a long weekend.  The robust market bounce today suggests that the fast money trade may already be over.

Regarding question 2, is quantitative easing the primary driver of higher stock values and investors should expect stocks to enter a secular bear market when the Fed tapers back on their easy money policy, we believe the answer is: there may be an adjustment process to investor expectations as QE Infinity is wound-down but the improving housing and labor markets will keep the economy and stock market on a growth track.

Shown below is a chart of weekly unemployment claims going back to 2000.  What is evident is this measure of the health of the labor markets has been showing significant improvement since early 2009 and is almost back to where it was during the 2004 to 2007 bull stock market run.

2013-05-28 B

The next chart shows new home inventory.

2013-05-28 C

The inventory of completed homes for sale is at a record low.  The combined total of completed and under construction homes is also just above the record low.  The tremendous oversupply of homes has been worked through the system and now home construction has to play catch-up to reach normalized levels.

The chart below shows new home sales and the blue bars show periods of economic recession.  Sales in April were at a seasonally adjusted annual rate (SAAR) of 454 thousand. This was up from 444 thousand SAAR in March (March sales were revised up from 417 thousand).  January sales were revised up from 445 thousand to 458 thousand, and February sales were revised up from 411 thousand to 429 thousand.

2013-05-28 D

From the standpoint of housing and jobs, it appears there is more to the market’s advance than just the Fed.  Additionally, corporate earnings and Gross Domestic Product are at all-time highs.  Corporate profits as a ratio of GDP is also at a record high.

2013-05-28 E

A steadily advancing economy with strong corporate profits will lead to a further tightening of the labor market which in turn will lead to rising wages and increased home demand.  The stock market is a forward looking indicator of expected economic conditions and we believe it is correct in showing improvement in the main-street economy over time.

The Delta Market Sentiment Indicator advanced this week from 70.4% to 73.3% indicating the market got stronger on a technical basis.  We will be opportunistic in opening new long positions on market pull-backs.

Open Positions:

None

Parting Shot: Market Sentiment Indicator

Shown below is our MSI (blue line) superimposed on the equal weighted S&P 500 measured by the ETF (RSP).   We are bullish on the stock market when the MSI is above the 50% mark and bearish when it is below.

2013-05-28 F

The scale for the MSI is on the left hand y-axis.  The MSI has increased from 70.4% to 73.3% last week.  With the MSI bullish in the intermediate term, we will look to increase long exposure on pullbacks.

Have a great week trading,

Nick Atkeson and Andrew Houghton
Editors
Big Money Options

 

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