All is well in the world! Or is it? The S&P 500 just went through an historic ascent from the mid October lows. On October 17th, the S&P 500 closed above the 5 day moving average and would not breach it again until 30 trading days later. This most recent rally of 14% off the October lows exhibited record momentum and was the most consistent rally ever. And ever is a really long time! At one point, the S&P 500 closed 5 straight trading days within no more than 0.07% of the previous day’s close. The complacency in the U.S. equity market is rather unreal when you consider no more than 6 weeks ago investors couldn’t sell fast enough. The most recent Investor’s Intelligence Sentiment survey recorded the second lowest reading of Bears (13.8%) since February 1987. In fact, the current ratio of Bulls to Bears (4.09) is in bullish territory rarely seen before. The two most recent readings of a 4.0 or higher ratio were a few weeks before the 6% drawdown in January/February of this year and the 9% drawdown in September/October of this year. So, with the S&P 500 at all time highs, historic momentum and significant complacency in place, is there any reason to worry? Let’s take a look at other measures to confirm the S&P price action.
- The Russell 2000 (small caps) continues to make series of lower highs and was basically unchanged for the month of November and up 0.82% YTD.
- The VIX (a measure of S&P 500 volatility) continues to make a series of higher lows and is down 2.84% YTD.
- The yield spread on U.S. Treasuries (10 year minus 2 year) continues to flatten and remains at a YTD low of 170 basis points.
- The CRB Index (commodities) is down 9.2% YTD and down 18.7% since its 2014 high set on June 20th.
- As measured by the BofA Merrill Lynch U.S. High Yield Master II Option-Adjusted Spread Index, credit spreads between junk bonds and U.S. Treasuries have widened 129 basis points since the low in spreads was set on June 23 of this year. In November alone, credit spreads between junk bonds and treasuries have widened 34 basis points.
- Since September 30th, S&P operating EPS estimates (bottom-up) for the 4th quarter of 2014 have declined 4.2% and estimates for 2015 have declined 1.6%.
None of these measures in of itself would point to a market susceptible of a correction. However, when taken as a whole, the S&P 500 looks quite vulnerable. The relative underperformance of the Russell 2000, a flattening yield curve and declining commodity prices have historically foreshadowed slower growth. As far as the S&P 500 goes, it would be ideal to see the VIX make lower lows and high yield credit spreads tighten as the market makes higher highs.
Currently, across all of Tandem’s strategies there are a total of 48 equity positions. Of these 48 holdings, 21 are valued as a sell according to our proprietary valuation model. Does this mean disaster is looming? Absolutely not. But, what it does say is caution is warranted. When putting all of the pieces of the puzzle together, (i.e. record momentum, historically wide bull/bear spread, indications of slowing growth and 44% of Tandem’s core holdings reporting a sell valuation) the risk appears to be skewed to the downside.
Now is not the time to be complacent, which is completely opposite of current market action. When everyone is on one side of the trade, very rarely is it profitable to jump on that side of the boat. Now is the time to stay disciplined, put together and implement a proactive investment plan. The worst thing you could do is follow the herd and react when everyone else is reacting. Don’t be afraid to sell when everyone else is buying, because eventually you’ll have the ability to buy when everyone else is selling. Buy low, sell high. It doesn’t have to be that complicated!
Billy Little, CFA
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