In a U.S. presidential election year, the media and public is always on the lookout for an ‘October Surprise’, an event or information with potential to change the course of the election. Many years, events in October have also surprised the market one way or the other. U.S. markets have crashed many times in October and it has earned a well-deserved reputation of a ‘bear-killer’ too.
Whether market will throw an October Surprise or not this year remains to be seen but there are many emerging patterns and potential events on the horizon that need to be analyzed to form an informed opinion about market’s current environment.
As expected FOMC did not raise Fed-Funds rate in its September 21 meeting. Next Fed-meeting is on November 2 and market does not expect Fed to raise rates in that meeting. The 30-day Fed Fund futures price indicates a 10.3% chance of Fed raising rates by 25 basis points in it. The probability for a 25 basis point hike increases to 55.7% in FOMC’s December 14 meeting.
30-Day Federal Funds Futures December 2016 contract closed the month at 99.515. Its price indicates 100 minus the average daily Fed Funds overnight rate for the delivery month, which means that the futures market expects that the Fed Funds overnight rate to be 0.495 or within the current target rate range of 0.25-0.50 percent.
The spread between 1-year Treasury yield and 2-year Treasury yield has been declining for many months. This means that the yield on longer-term bonds is rising less than on short-term bonds. This tells us that the market does not foresee stronger growth and higher inflation in the current environment.
Raising Fed Funds rate in this environment will be a tough decision, nevertheless, the conventional wisdom is that Fed will raise rates in December. In her many speeches and congressional testimonies, Chair Yellen has emphasized that the Fed is data dependent. The Fed has also shown that it considers many things including global economic situations. We believe that chances are good that Fed may raise rates in December, but the data and global economic conditions may not support Fed’s decision for long.
Focus On December Meeting
The December meeting is approximately ten-weeks away and many important economic reports will come out before it. Here are, what we believe, some meaningful levels. The 4-week average unemployment claims need to stay near its current level of 256K, which is highly likely. Three Non-Farm Payroll reports will be released before December meeting. These reports should not disappoint, the 3-month average employment gain should be close to 200K and the trend should point up. The current 3-month average is 233K, which has increased for the past three months after falling for five months before that.
The CPI should also be in a healthy range and show that it is rising up to Fed’s target rate of two percent. At present, the CPI is 0.6% and the Core CPI is 2.4%. Fed’s favorite measure Core Personal Consumption Expenditures (PCE), was up by 1.9% year-over-year in August. The inflations expectations should show higher readings. The current trend of University of Michigan Inflations Expectations survey is down.
The psychological indicators that we follow are not flashing any strong signal one way or the other.
Bullish Vs. Bearish Advisors %
This is a contrarian sentiment indicator. The bullish sentiment with Investors Intelligence Bullish Advisors % has moved down to 45.20% from 55.90% in August. The Bear Advisors % has moved up to 23.10% from 20.60% in August. When the percentage of bears crosses over the bulls, the market bottom is likely. Last time bears were over bulls was in March 2016.
AAII Investor Sentiment Survey
As of September 30 2016, 24.0% of members of AAII are bullish regarding markets direction for the next six months. compared to 37.1% of members who are bearish and 38.9%, who are neutral. One month ago, these numbers were 28.6%, 31.5% and 39.9% respectively.
Bullish and bearish percentages are below the historical averages of 38.5% and 30.5% respectively. The neutral percentage is above the historical average of 31.0%. The bullish sentiment is at the 8-week low.
At extreme readings, this gauge works as a contrarian indicator but at other times, it provides signs for future direction of the market. We have found that the current slope of the 4-week simple moving average of the bullish percentage gives a good sign for the slope of the S&P 500 4-weeks later. In the most recent reading on September 29, the slope of bullish percentage and its 4-week average is down. After making 2016 high during the week of July 28, the 4-week average has mostly declined. This does not bode well for S&P 500, however, it just gives an indication regarding the direction and not the magnitude of the move.
CBOE Market Volatility
September saw an increase in the market volatility. Before September 9, S&P 500 had not closed more than 1.0% – in either direction – from previous day’s close since July 8. At the beginning of September, $VIX, the CBOE Market Volatility Index, was at 13.42. Early in the month it declined reaching a low of 11.77 on September 7. It then spiked and reached a high of 20.51 on September 12. For the rest of the month, though the volatility didn’t decline but the fear level also did not rise.
$VIX ended September at 13.29, which is lower than the 12-month, 24-month and 60-month averages. It is also below 20-day, 50-day and 200-day averages. The fear gauge can stay at a low level for an extended period.
A contrarian sentiment indicator that helps determine major and short-term market tops and bottoms is the Put/Call Volume Ratio, which compares the total number of puts traded with total number of calls traded. The current ratio stands at 0.932. A reading above 1.15 usually confirms a positive reversal.
The 10-day moving average gives a better indication of short-term bottom. The current value is in the middle of the range. Following Brexit referendum, the ratio reached 1.170 and the index turned around.
This is a IBD proprietary indicator that helps in determining rebounds from immediate corrections during bull markets. It was at 2.00 at the end of September. A short-term bottom usually occurs when it turns up for the first time after crossing below 0.5. During bear market this threshold level drops to 0.1.
Another contrarian indicator that denotes the year-over-year change in margin debt, which can help flag major tops in bull market. When optimism is high this will exceed 55%, which means that investors are borrowing heavily during the late stages of bull market. At the end of September, it was -2.62%, which means that the investors have cut their margin debt from the year-ago level.
At the end of September, the earnings report card for S&P 500 companies is mixed. The 12-month forward P/E ratio is high but is not in bubble territory. There had been many periods in the past when the ratio was higher, which means that S&P 500 has more room to run higher..
Better than Average
For Q3 2016, the earnings of S&P 500 companies is estimated to decline by -2.1% from a year ago level. If this happens then it will extend the streak of year-over-year quarterly decline to six, a first since 2008. The revenue is estimated to grow by +2.6%.
On June 30, the estimates were for a growth of +0.3% in earnings. According to FactSet, analysts have lowered the Q3 earnings by -2.9% from $30.65 to $29.76. This is better than the four quarter and five year averages of -4.9% and -4.3% respectively. The negative EPS guidance for Q3 issued by S&P 500 companies, 70% as of September 30, is below five year average of 74%.
Analysts don’t expect the earnings growth to return until Q4 2016, when the earnings growth is estimated to be +5.6% and revenue growth +5.2%. For the year 2016, the projection for earnings is a decline of -0.2% and for revenue a growth of +2.0%. The corresponding number for the year 2017 are +13.00% for earnings growth and +6.1% for revenue growth.
Forward P/E Ratio Above Average
The forward 12-month EPS for S&P 500 companies is $129.65. This means that at the end of September, the 12-month forward P/E ratio is 16.7, which is above 5-year and 10-year averages of 14.3 and 14.8 respectively.
Chart 4 shows that the forward 12-month EPS is still in a uptrend, which looks good for S&P 500. For most of Q3, the change in S&P 500 EPS was been trending down but the price was holding well (Chart 5), which again bodes well for the index.
October has been quite volatile month in the sense that many big decline days occurred in it. The market crashed in October 1929, 1978, 1979 and 1987. Dow Jones Industrial Average lost 554-points (-7.2%) on October 27 1997, 733-points (-7.9%) on October 15 2008 and 190-points (-6.9%) on October 13 1989. However, as Stock Trader’s Almanac notes, October also has been a turnaround month. The market reversed from twelve bear markets in October since World-War II.
Dow Jones Transportation average has performed better than other indices in October. Since 1970, it has been up 88% of time in October with average gain of +1.8%. Since 2000, it has been positive 72% with average gain of +3.7%. This is not surprising based upon October being a ‘bear-killer’ and transport usually turn around before rest of the market.
Small cap Russell 2000 fares the worst. Its average monthly change since 1970 is a loss of -0.7% even though it was up 69% of times. Since 2000, it has logged an average gain of +1.5%, which is still lower than other indices, and only 55% up ratio. Russell’ performance is also not surprising as small cap lag the large- and mid- cap stocks in the early stages of a bull market.
Since early July, the 30-Year US Treasury, $USB, (top panel Chart 7) price has been falling. In early-September, it broke below prior support levels. In the candlestick chart with day’s high and lows, the break is from a descending triangle (not shown here). The price bottomed in mid-September, and started to bounce. Whether it will be sustained remains to be seen.
In September, S&P 500 (second panel chart 7) lost -9.75 points but the chart tells a different story. It fell earlier in the month, then it advanced and then it moved sideways. Bonds (third panel Chart 7) were in sync with S&P 500 till last few trading days of the month. If this break in correlation persists then it will not bode well for stocks as bonds turn direction before stocks.
Since the middle of September, commodities, as represented by Reuters/Jefferies CRB Index, $CRB, have been moving up. During this period, U.S. Dollar index, $USD, has been generally trending up too (bottom panel Chart 7). This is different than what we noted in our September report and indicates that inflation is beginning to show.
A large part of the up-move in $CRB is due to crude oil’s climb from the low of 39.26 in early August-August following a pullback from a high of 51.67 reached in early-June. In our opinion, six-month delayed slope of crude oil has good correlation with the CPI (Chart 8). Six months ago, at the end of March, West Texas Intermediate (WTI) Light Crude Oil closed at 38.34. On September 30 it closed at 48.24.
The WTI Light Crude Oil futures continuous contract, CL #F, is forming a symmetrical triangle after reaching a high of 51.62 on June 8. This high was at the prior high of 50.92 reached on October 9 2015, which acted as a resistance. The price then pulled back to a low of 39.26 by August 2. The pullback was to the 50% Fibonacci retracement level of crude’s rally from the low 26.05 on February 11 2016 to the June high.
On September 29, crude broke above the symmetrical triangle. The next resistance is at 55.34, which was the gap-down on July 6 2015. The 100% target of the triangle is 59.81, which is near the high of the congestion zone that crude formed in May-June 2016 after rising from swing low and before tumbling down lower.
USO, the United States Oil Fund ETF, also formed a symmetrical triangle like the futures that it tracks. It too broke above the triangle on September 29. The measured target of pattern is near 14.03, which is 26.3% above October 3 closing price of 11.10.
Following the Brexit referendum in late June, the global equity markets declined sharply. In the third quarter, most global markets recovered majority of the ground that they lost post-Brexit referendum.
In August, S&P 500 remained in a horizontal trading channel at an elevated level. September saw it first decline from those high levels and then stage a rebound in the second half of the month.
Naturally, the component sectors behaved similar to the parent index, but not all fared similarly (Fig 3). Financials and consumer staples were the worst performers followed closely by materials and utilities.
Only two S&P 500 sectors, energy and technology, were positive for the month and did better than the broader index itself. Two others, industrials and health-care, also did better than S&P 500 but were negative for the month.
The charts of three sectors, energy, XLE (Chart 11), industrials, XLI (Chart 12) and technology, XLK (chart 13), are in an upswing and showing greater potential going forward.
In September, both, the developed markets and emerging markets as groups, outperformed S&P 500. For the month, EEM, iShares MSCI Emerging Markets ETF, was up by +2.5% and VEA, Vanguard Developed Markets ETF, was up by +1.2% but SPY, S&P 500 SPDR, was down by -0.5%.
VEA has been in a uptrend since mid-February (second panel Chart 14). After making a high in middle of April it pulled back till mid-June before starting on another leg up which has taken it higher than previous high. It started to outperform S&P 500 after June (first panel Chart 14).
The chart of EEM (Chart 15) is similar with minor differences. It started the upswing a month earlier than VEA. It also started to outperform SPY from January instead of July for VEA.
VEA follows the FTSE Developed All Cap ex-US Index, which is a market-capitalization-weighted index made up of approximately 3,700 common stocks of large-, mid-, and small-cap companies located in Canada and the major markets of Europe and the Pacific region. The top countries represented are Japan, United Kingdom, Canada, France, Germany, Switzerland, and Australia.
The best performing countries included in VEA in September are, Australia (+3.4%), Japan (+2.1%) and Canada (+1.4%). The top 3-month performers are Germany (+9.2% – EWG, Chart 16), Japan (+9.0% – EWJ, Chart 17), Australia (+7.5% – EWA, Chart 18) and Spain (+7.4% – EWP, Chart 19).
EEM tracks the investment results of an index composed of large- and mid-cap emerging market equities. The top country holdings are China, South Korea, Taiwan, India, Brazil and Russia.
The one-month best performing emerging markets are Taiwan (+4.5%), Russia (+3.5%) and South Korea (+3.2%). The top 3-month performers are Brazil (+11.1% – EWZ, Chart 20), South Korea (+8.2% – EWY, Chart 21), India (+7.4% – EPI, Chart 22) and Taiwan (+7.0% – EWT, Chart 23).
Global markets are poised delicately for some time. After making all time high in July 2015, S&P 500 waited a year before climbing higher. Since then it has been meandering within a narrow range. This makes investors nervous and their nervousness is compounded by the guess-work being done to figure out if and when the Fed will hike Fed-Funds target rate.
Following last rate-hike in December 2015, Fed hinted that it may raise rates four more times in 2016. Three-quarter of the year has gone by and it has not yet delivered. Now there is only one meeting left in which it can realistically raise rates. This has added to the anxiety.
Europe is facing banking problems connected to its sovereign debt, monetary issues and political constraints. On top of that, Deutsch Bank, a premier bank in Germany, is facing existential threats. U.K. Prime Minister May’s recent speech has brought the Brexit issue to the forefront again.
Seasonally, October is prone to volatility. During the U.S. presidential year, October has ranked last among all months. Usually, it also starts the seasonal rally in the market.
Considering all these it may not be far-fetched to think that this year too we may get a ‘October Surprise’ in the market. There are no concrete signs on the horizon that would make such an event a certainty but probabilities of it happening are not very low too. In our opinion, the general direction of the market remains to the upside but would still be prudent to stay nimble and cautious.