FYI | Jun 29 2009
By Greg Peel
“There is an old saying in the markets when contemplating the end of a bear that is transitioning into a new bull market,” notes Brian Pretti of Financial Sense Observations (financialsense.com). “First comes price, then comes optimism, and then come earnings”.
The story of the June quarter in the US (and thus reflected across the globe) is that we have achieved price, beginning in March, and the kick-on to 40-45% gains has been driven by optimism. Now its time for June quarter earnings to step up to the plate. The quarterly earnings season in the US will begin soon and market response (as opposed to the results themselves) will be critical. The March quarter earnings season was well received, but very much in “less bad” sense. Wall Street was primed for some shocking results given analysts were reluctant to overestimate yet again. They weren’t quite so shocking, and thus became part of the “green shoots” rally.
Because they weren’t so bad, Wall Street will be looking for confirmation from June quarter results. Which way have analysts gone this time? Are they still timid or have they become all excitable again? The world does not want to see too many “misses” (actual results coming in below analyst consensus forecasts) but would rather companies can again “beat the Street”. At the very least, results and ongoing guidance must be in line with forecasts if this rally is to be ratified. Fund managers entered the June quarter underweight risk assets. There has been a flurry of reweighting, but confirmation is needed.
The result season is crucial given a disturbing trend. Brian Pretti’s analysis shows that recent volume levels on the New York Stock Exchange indicate momentum is fading, and fading fast.
For a bull market to take shape, there must be support from stock market volumes. A market rising on low volume simply implies a small but optimistic breakaway group has shot up the mountain, goading the peloton to close the gap lest it be left behind. Recently Wall Street momentum has clearly faded, given the indices have not advanced. The 946 high in the S&P 500 was posted on June 12. Friday night’s close was 918. The lack of fresh momentum is unsurprising given low trading volumes.
Volumes on the NYSE have actually been trending lower for some months now. But one must remember the late 2008 bail-out featured high volumes. The market has settled now so it is no surprise volumes have come off their peaks. What’s more, earlier “green shoot” data have given way to some more circumspect results. Has momentum faded because volume has weakened, or has volume weakened because momentum has faded?
A more enlightening analysis to conduct, Pretti explains, is to concentrate on “up-volume” – the specific volume on days when the market moves higher rather than lower. If a market advances on strong volume, but falls back only on weak volume, it is fair to conclude the trend remains to the upside. Unfortunately the charts do not tell an encouraging tale.
In the above chart, the upper blue line represents the 15-day moving average of up-volume over the last two years as compared to the lower black line of actual S&P 500 movement. The last peak in the blue line indicates volume took off in March just passed, peaked in April, and collapsed in June. The red vertical lines correspond with points from which the S&P 500 took another dive over the period. As the red lines indicate, these are always accompanied by a drop-off in up-volume. In other words, a drop in up-volume is almost always a harbinger of a drop in the index ahead.
For those trying to call the beginning of a new bull market, Pretti notes, a comparison to 2003 has become popular. In 2003 Wall Street turned around from its post-tech wreck, post-9/11 recession and the great bull market of 2004-07 began. Comparisons of index charts from the time are feeding the positive view.
The following chart highlights that when the S&P 500 turned the corner in 2003 – coincidentally in March – up-volumes initially shot up just as they have done in 2009. And then they peaked in April and dropped rapidly again, just as they have in 2009. Yet that drop-off in 2003 was to prove simply a blip, and strong volumes returned thereafter to provide enough momentum to give the new bull market its foundations.
Could 2009 see a repeat of 2003?
The first thing to note is that in 2003, up-volumes recovered in May and pressed higher in June, which is not the case in 2009. Nevertheless, there is no rule to say every month must play out exactly the same. What is more important is that the low in the up-volume reached in April was still a lot higher than the low achieved at the end of the bear market in March. As the first graph above indicates, up-volumes have fallen back in 2009 to reach the same low point they reached at the bottom of the market.
And that is why the upcoming quarterly result season in the US is so crucial. For there to be any hope that now is the time to call a new bull market, there will need to be a last-minute turn around in up-volumes, and not just because of any end-of-quarter window dressing we might see this week. If the earnings season disappoints, it is likely up-volumes will continue to fade and the groundhog will come out of his burrow and not see his shadow. There will be more winter ahead.
The picture does not look any brighter once Pretti makes further comparisons of the up/down volume ratio. From February to June 2003 this ratio peaked and troughed several times before the index turnaround was confirmed. Yet each successive trough was higher then the previous trough. Over February to June 2009, the same peaks and troughs have occurred, but each successive trough has been lower than its predecessor.
A similar picture is painted by the 14-week relative strength index in each period (for those familiar with this technical tool). A reading below 50 indicates bearish weakness, and above 50 bullish strength. In 2003 the RSI crossed back above 50 in the first quarter and then remained above it for the next five quarters. In 2009 the RSI crossed back above 50 in the first quarter and held just above – right up until a couple of weeks ago, when it slipped just below.
The RSI regained 50 late last week, but that might simply reflect aforementioned end-of-quarter window dressing. How the S&P 500 fairs in July will be crucial.
As a footnote, respected Morgan Stanley analyst Gerard Minack makes further note of what financial markets have taken recently as another bullish sign – that credit spreads have improved a lot recently.
Given the Global Financial Crisis has been all about credit markets, those normally focused on stock markets have been forced to become amateur credit market experts very quickly. Credit spreads peaked in late 2008, but have since retreated quite markedly. A credit spread represents the extent of interest rate required by a lender to provide funds to a corporate borrower. In the post-Lehman panic, credit spreads unsurprisingly shot up.
The stock market has taken the subsequent retreat of credit spreads to mean lending confidence has returned, and that can only be healthy for an economy looking to get back on its feet. But Minack warns that the recent contraction of spreads is merely representative of just how wide those spreads had become (equivalent to Great Depression era spreads) and thus just how “cheap” corporate debt securities had become for the more risk hungry trader. If the S&P 500 had reached 250, suggests Minack, the same response would have occurred in the stock market. It would just be too cheap.
“Consequently,” says Minack, “while credit markets have rallied, in many areas credit fundamentals have worsened. These credit headwinds are likely to affect the recovery in ways that will damp the economic rebound.”
