Here we go again

This year promises to be as challenging as last. Let’s try to get through as unscathed as possible.

PORTFOLIO POINT: Mixed signals on the market outlook tell me it’s time for investors to lower their expectations.

My yoga teacher said to me over the break: “We often ask for things that we don’t get, however we are not often thankful for what we have.” Despite what the majority believe, 2012 will be another challenging year. Investors should lower their expectations and try to get through as unscathed as possible. My mantra for 2012 is to be thankful for what I have and anything else will be a bonus.

The break’s over, it’s time to lock horns with the market and try to decipher what is happening. Let’s kick the year off with the positives. Dr Copper has broken out of its pennant formation to the top side and the Chinese Index has managed to rally 6% in the past week.

My four key focus points for 2012 are: BHP holding the $34 level (head and shoulders top formation), the S&P 500 not confirming its huge head and shoulders top formation on the weekly chart, the Advance/Decline Index on the S&P 500 not breaking down and Richard Russell’s Primary Trend Index not breaking below its 89 day moving average.

All four of the above indicators have not only not broken down, they have improved. My own Proprietary Offshore Funding Index has come back down to more manageable levels.

There is no doubt that the recent action by the European Central Bank to flood the system with cash has brought down the cost of short-term funding dramatically. But we are only halfway through January and, as highlighted in my last note, the world’s biggest economies face $7.6 trillion bond tab in 2012.
Now the bad news.

On first glance there is not much wrong technically with the US markets. The S&P 500 has been trading above its 200-day moving average for the past nine trading days and we have broken the October highs. But not all is as it seems. While the Dow Jones, the Transport Index and the Russell 2000 have also broken their October 2011 highs, both the Nasdaq and the Philadelphia Semiconductor Index have not.

Volume has been light and market sentiment is at extreme bullish levels. In the past this has led to equity market corrections. Two weeks ago there were extreme readings from the American Association of Individual Investors and last week was no different, with a reading on my Bull/Bear Index slightly higher.

Another ratio that is used to gauge investor sentiment is the CBOE Equity Put/Call Ratio. This index tracks the ratio between the total volume of equity put options over total volume of equity call options.

Like the Bull/Bear Index, this is a contrarian index. A low reading of .50 means that there is twice as much money going into equity calls as into equity puts. This tells us that traders are getting very confident of an impending market rise.

This index finished the week at .61, but on Thursday it had a reading of .55, and as you can see on the chart below, the five-day moving average is approaching levels not seen since mid-2011.

The CBOE Equity put/call ratio is not a stand-alone method of determining tops and bottoms in the equity markets, but when combined with other sentiment and momentum indicators, it can be a powerful tool to give us greater confidence.

The VIX, or the Fear Index as it is affectionately known, is another tool used to gauge market sentiment. The VIX calculates the implied volatility of the S&P 500 index options with a 30-day duration. Essentially this index gives us a view of traders’ expectations on future market volatility.

The VIX can often help us determine turning points in the S&P 500. When a new high on the S&P 500 is not confirmed by a new low in the VIX, it can be a clue that the rally is fading. On Thursday the S&P 500 made a new high (just) but the VIX failed to confirm with a new low.

The Citigroup Economic surprise index is a great leading indicator. It measures the variations in the gap between the expectations and the real economic data (actual releases vs Bloomberg survey median). The Citigroup Economic surprise index topped last week. It made a higher high but was not confirmed by the RSI. I expect this index to fall as the year rolls on and if I am right, combined with the sentiment indicators above, the chance of a correction in the US equity market is high.

The chart below compares the Citigroup surprise index to the S&P 500. Since 2006 there have been six occasions when the index made a reading of 70 or higher and then headed lower. On four of those occasions the S&P 500 followed that trend in the weeks preceding, falling a minimum of 6.25%, with the steepest fall being 45% in 2008.

The index recently made its second-highest reading of all time at 91.90 and on Friday closed at 72.40.

It’s worth noting that another leading indicator, the ECRI Weekly Leading Index of US economic growth (below) had another downward tick last week. After falling like a stone down to -10 in mid-October it staged a recovery, but has fallen from -7.60 to -8.40 in the past two weeks.

This indicator has a good record of predicting recessions, which it is predicting for the US this year.

The US Banking Index has been performing well of late, but has now hit its 200-day moving average, as the chart below demonstrates. If the market is going to push higher as many predict, it will need continued leadership from the financials. Let’s see how the financials fair as reporting season gets going in earnest this week.

JP Morgan’s fourth-quarter results were not encouraging on Friday night, with profit down 23%. We hear from Citigroup, Goldman Sachs and Wells Fargo this week.

The bond market is telling us something different about punters’ appetite for risk. The chart below of the Barclays Capital High Yield Bond ETF is a case in point. In a risk-off scenario like we had in late September, investors shun high-yield, high-risk bonds. As you can see on the chart, the ETF crashed in late September, along with the equity market and then recovered along with the equity market to make its October high.

The point to note here is that while the S&P 500 has bettered its October high, this ETF clearly has not. In fact we are still 4% from those highs and trading below the 200-day moving average.

The chart below of US 10-year notes in yield not only shows that they are 54 basis points away from their October recovery high in yields, but are actually lower in yield than November 25th when the S&P was trading at 1150.

I read a research piece last week from GaveKal Research, stating that “structural equity bull markets rest on three pillars: attractive valuations, expanding economic activity and excess liquidity”.

They believe those three criteria are with us now. After recent central bank intervention, I agree on excess liquidity. However, I am in the deflation camp and believe that the sheer amount of debt that the world carries may even be too big for the world’s central banks’ printing presses to overcome.

While the economic data improved towards the end of 2011, I think you will find that it will begin to deteriorate as 2012 progresses. As for valuations, the US earning seasons will soon tell us if the E in P/E (price/earnings) is as bullish as most analysts are expecting.

I could of course be too pessimistic and I realise that I start 2012 like I finished 2011, but while the bond market so emphatically disagrees with the equity market, I won’t be getting bullish with the crowd.

In fact for aggressive traders, considering the S&P 500 has rallied 20% since October and considering the points I have outlined above, shorting the S&P 500 with a stop about 1% above recent highs is a great risk reward trade. Also I have bought the VIX and some VIX call options, just in case Greece exits the euro, which I rate as more than an outside chance. Investors should remain defensive.

All the best for 2012 and if you work in finance and your boss asks to see you this month, look busy and important.

Tom Lovell is an analyst and independent investor.