Putting the "sell-off" in perspective

Viewed from the perspective of the 26% gain in the S&P500 since September, last week's 1.7% decline in the S&P500 did very little to dent the uptrend. Volume on the decline was modest and compared similarly to the volume on a short bout of selling in late January.  The worst of the decline also compares to the decline experienced in November. So as declines go, the current Mideast tumult was no different than the two prior declines.  See the chart below:

One indicator we watch is S&P500 stocks trading over their 50-day moving average. As expected, this indicator dropped but found support at levels of the November setback, indicating no major damage at this time.

Dow Theory is a bit precarious as the Transports took a larger hit than Industrials last week as the price of oil surged. The index settled at support near 5,000 at its late January lows. A close below support would constitute an intermediate-term downtrend and a red flag.  See the chart below:

Last week's selling in equities attracted a bid to Treasuries, as the 30-year Treasury Bond price bounced over 2% on the week. Other than this unsurprising reaction to the decline in equities, all other indicators remained positive for equities despite modest pullbacks as their main trends remained unchanged.

Some of our trailing stop hedges on the uptrend were executed last week.  While we continue to maintain stops on our long positions, we added some new longs as the market sold off, anticipating a potential "buy on the dip" as buying pressure nonetheless remains intact (we saw a nice bounce on Friday).  With a weakening dollar and outperformance of small caps, we find the large cap universe increasingly interesting.  Also interesting is emerging market equities, having sold off over the last several months.

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Joining the Crowd

As more bullish equity enthusiasts join the uptrend, equities are increasingly vulnerable to a shock that, by all indicators, will be addressed with "buying on the dip."  The buying pressure in equities continues to track with the persistent growth in bullishness among investment advisors. Our trend-following indicators flash green throughout. Some noteworthy trends:

Small caps and growth continue to outpace large caps and value. After hitting trendline support in early January, the ratio of small vs. large cap continues to shine, following a steady uptrend since the bottom in March 2009. We are watchful for a peak in this outperformance leading any peak in the S&P500. The small cap/large cap ratio last peaked about 18 months before the peak in SPX:

US equities maintain their relative strength lead vs. emerging markets, a lead which formed in November 2010.  Bubble talk of China real estate, geopolitical risk and rising inflation and monetary tightening in emerging markets have encouraged outflows into developed market equities.  This might present an opportunity for selective investment in certain emerging markets vs. others. Technically, Malasia (ETF symbol EWM),  Indonesia (ETF symbol IDX) and South Africa (ETF symbol EZA) have seen some impressive bounces. This contrasts with MES (The Gulf States ETF) as one can expect has lagged emerging markets due to continued political unrest:

As for other positive signs for equities, Dow Theory remains consistently bullish as the Transports reached a new recovery high, following the lead of the Dow Industrials.  Strong relative strength growth in Corporate Bonds vs. Treasuries, a measure of risk appetite and preference for stocks, also continues. We added a relative strength ratio of LQD (the iShares iBoxx Investment Grade Corporate bond ETF) vs. S&P500 at the bottom of the chart (below). Note the price crossing its 34-day moving average indicating turns in preference of equities vs. bonds. This signal has been on an intermediate-term  "buy" on equities since September:

We continue to see lagging performance in the Nasdaq vs. the S&P500. This likely represents concentration in money flows into a broader mix of sectors (industrials, materials, financials) versus the tech-heavy index. We are a bit cautious toward putting too much credence in this relationship, however, as QQQQ, which is the ETF that holds the Nasdaq 100 stocks, is weighted 19.74% in Apple Computer and is therefore heavily influenced by this particular stock.  APPL has been lagging the SPX since mid-October 2010.

Our trend-following strategy keeps us positive on equities. We are very comforatble with partial hedges on these longs, however, with index puts on SPX and trailing stops to protect profits.

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More positive indicators support the uptrend; time to be cautious?

Equities appears to be running on all cylinders, as most indicators remain positively bullish.

Our Dow Theory indicator has turned more positive as Transports surged last week and remain 4% off their 2008 high. We like to see the Dow Industrials and Transports move consistently to lend support to the uptrend. See the chart below:

VIX remains low at 15.7, matching the lows reached in late 2007 through May 2008 (and, more recently, April 2010). Low volatility has introduced bargain prices on options; those seeking protection can purchase cheap puts, while those joining the bullish camp can find inexpensive calls (many in-the-money calls sell for barely any premium over intrinsic value). The gap in VIX price vs. its moving average, once again, is wide enough to suggest that a bit of caution is warranted for equity bulls. See below:

Our NYSE McClellan Oscillator closed positive on all counts last week, underscoring strength in advances vs. declines and the broad participation of most equities in this uptrend. See the chart below:

At this stage of the rally, one would expect laggards to start catching a bid. One such laggard has been the Staples sector, and there is no sign of catch-up from this group. Staples have been lagging Discretionaries, and this relationship was pronounced last week as the latter sector surged above its 16-day moving average and handily beat the sluggish Staples sector (food commodity inflation may be taking some toll on the group):

Underscoring the strength in the "risk-on" trade is the performance of our US Treasury/Copper Futures ratio,  This ratio broke out to a new high (breaking resistance hit in 2006, 2007 and 2008). The COPPER/USB ratio underscores inflationary pressures. A rising Copper (or CRB) denotes inflation, while declining bonds (and corresponding higher interest rates) also support inflationary tendencies.  The COPPER/USB ratio does a fine job confirming the trend in the equity markets (see the chart below with SPX plotted at the bottom):

Asian equities continue to take the heat and lag US equities. Tightening monetary policy through rising interest rates in many Asian countries is inducing fund outflows which are finding their way back into the US. Our EPP/SPX ratio (the iShares MSCI Pacific ex-Japan index vs. the S&P500) broke trendline support this week (as the dollar strengthened too), underscoring a shift in sentiment toward the US. See the chart below:

Prices of 30-year US Treasuries rose slightly on the week but continue to linger near a support shelf near 115. Testing support will be key and we will watch this behavior for signs of a reversal (and potential coincident decline in equities). At these levels, some allocation back into bonds may be a prudent move:

Other indicators remain positive. Our Corporate Bond/US Treasury ratio continues to support the uptrend in equities. Small Caps outperformed Large Caps, and Growth outperformed Value. Signs of these relationships changing will indicate an improvement in lagging sectors and will underscore an aging uptrend in equities.

Even in the historically weak month of February, dips appears to be bought as buying pressure remains. It is under these conditions that a surprise selloff triggered often by some unsuspecting event catches us off-guard.  With options prices remaining inexpensive, it may be wise to protect one's equity portfolio with an index-based put (i.e. one-month SPY puts) as insurance.

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Market Tour Update

Equities push toward recovery highs, yet subtle signs of an aging bull continue to fester in our market indicators.  

On the positive side, one indicator we watch is the relationship between copper prices and the 30-year Treasury price. This serves as an indicator of economic growth expectations. As the price of copper (a proxy for industrial metals and hence economic growth) rises, and the price of treasuries falls (rates rise), bullish expectations toward economic expansion prevails. This ratio (Copper Vs. $USB) broke through resistance this week as marked by peaks seen in 2006, 2007 and 2008, and is a solid reinforcement of the uptrend in equities.  See the chart below:

The CRB likewise has seen strength in industrial metals and agriculture (manifested in global price increases for food), despite the weakness in Gold prices as the "risk-on" trade (favoring equities) has re-emerged.

We also saw a surge in our LQD (corporate bond price) Vs. IEF (intermediate-term Treasury bond price) ratio. Historically, a flat to rising trend in this ratio has been positive for stocks.  See the chart below:

Pacific markets have outperformed US equities since April 2010, but have given up that performance since Q4 2010. Although money has been flowing out of emerging markets (and bond funds) and into US equities, we believe this outflow has been overdone; our ratio of EPP (MSCI Pacific ex-Japan ETF) vs. the S&P 500 has found support off a rising trendline formed since early 2009.   See the chart below:

On the downside, once again VIX has turned complacent, falling from its spike to 20 back down to below 16. For the Bulls out there, this would suggest cheap call options to participate in the rally. Another negative is the continuation of Dow theory divergence, as the Dow Jones Industrial Average closes in toward its recover high while the Dow Jones Transports lag (and fall). Airlines have been particularly weak, as rising oil prices may be taking its toll on the index. See the chart below:

Asset allocations out of bonds (and emerging markets) into US equities have helped to extend the current rally.  February tends to be a weak month for equities, however, so we will position our expectations on the cautious side to protect our equity gains.

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