Stock Market Surge Ready For Pause

Buy Signals in Need of a Break

Within a couple days of the spike lows in stocks on January 20th and February 11th after testing 15% correction lows in the SP 500 Index and 20% in the Nasdaq, we published updates indicating extreme oversold signals. Some of these Buy signal readings have never failed to indicate that an area to Buy stocks was at hand. Over the past decade these metrics have signaled a rally was due for at least the ensuing several months. The sharp appreciation in the stock market over the past 4 weeks have sent the tech heavy Nasdaq Index 12% higher and 10% gains in the benchmark SP 500 Index and Dow (DJIA).  It will still require rallies of 10 and 7% respectively to reach record new record highs in the major averages again, but before such a milestone is confirmed a healthy pause is likely.

The fundamentals still contain plenty of recession risk. Brazil is in its worst Depression in over 100 years. Emerging markets have collapsed with Oil prices that have exposed the global vulnerability to excess debt and a secular surplus in global production. Commodity over supply will remain a significant impediment to global growth in 2016 – 2017 and commodity rallies in the 1st half of 2016 are likely to be partly erased before year end as industrial capacity continues to be right-sized in producer nations.

 Technically, despite expected short term corrective price action in March, the picture is more ebullient as the January-February oversold readings in breadth, momentum and sentiment imply that a stock market reversal to sharp new lows is a much lower probability over the next few months. As long as the February low in Oil holds and an our forecasted upside confirmation to the upper $30’s in Crude occurs, then confidence in a further stock market rally will increase. Oil fundamentals of supply and demand remain terrible, but seasonality allows for a cosmetic covering of the unsightly warts that have plagued markets over the past year. 

Too Many Calls

Sentiment readings indicate a pause in the recent stock market surge is due to start within days. Short term trader sentiment using a ratio of negative put option purchases divided by optimistic call option volume has a good track record of signalling short to medium term overbought and oversold levels in the stock market. High Put/Call ratios in January/February over 86% indicated too much pessimism and low ratios under 62% begin to indicate high levels of trader optimism. The 60% level hit today is a bit oversold on an nominal basis, but certainly a move to more extreme readings in the lower 50’s is possible should this market rally sustain strong upside momentum for a few more days. Looking at a 3 Standard Deviation (SD) move lower in the Put/Call ratio after a market rally often indicates that it’s time for a breather and often foretells short term market turns. The SP nearby resistance of swing targets and 200 day moving averages in the 2008 – 2024 SP 500 Index zone point to an inflection point this week (ideally 03/07/16) that could turn prices to the downside for 2 to 4 weeks.

 

Looking back 5 years there have been 8 occurrences of a >5% SP rally followed by a 3 SD move lower in the 5 day Equity Put/Call option ratio. In 7 of these events there was a minimum of a 2 week correction that quickly followed such an overbought sentiment reading.

Bad Breadth

Breadth isn’t bad, in fact it’s quite strong and supportive in the context of a longer time horizon. However, short term stock market surges form oversold zones that generate >90% of stocks rising above their respective 20 day moving averages are often an indication that a small correction is approaching quickly.

 

While this report is focused on the downside risk over the next 2 to 4 weeks for stocks, we have a more nuanced outlook for 2016 as a whole. High Yield Junk Bonds are currently moving in tandem with equity markets indicating improving confidence that Oil prices may have bottomed at $26 for now and the rising energy default risk will avoid systemic credit tightening that could panic market valuations lower.  Without a rebound in Oil any overall earnings uptrend will be muted and any new low in oil prices will trigger new lows in stocks. However, our 2015 forecast for seasonal weakness in energy to end in February should at least support the initial Earnings (EPS) forecast by FactSet.com (below) calling for a sharp profit rebound into mid-year and beyond. The consensus EPS forecast in the 2nd half of the year looks ambitious given our expectation for renewed over supply concerns during the later part of the year slowing the earnings rebound. Until mid year, if FactSet is correct and our modest rebound in Oil prices is confirmed, then stock prices will continue working higher led by the energy and materials sectors initially. Thus, despite the worst 6 month performance in earnings since the 1st quarter of 2009 and a return to only slow global growth this summer, it’s quite possible that new record highs in stocks can be reached as early as this summer. Any commodity reversal with Oil below $26 will quickly blow up the record earnings forecast for year end 2016.

 

The capital intensive bore sizing industrial sector we deal with personally is clearly in recession and in need of rising commodity prices prior to customers elevating their capex budgets. Yet our stock market and materials sector may not need commodity markets like Oil and Gas to surge higher in order for capital spending to rebound, but merely a modest bounce followed by a more stable trading range. As we see here (below), energy and commodity trends can strongly influence the global economy and earnings. The headwinds of shrinking industrial and resource capacity should continue to limit GDP growth rates in 2016, but seasonal cycles and accelerating stimulus in China, Japan and Europe should provide the stability for better growth and higher stock prices once the stock market completes a modest correction in March.

 

As always, keep an eye on Oil and High Yield Bonds (HYG)!

 

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