While it is hard to imagine, this year has been the most uneventful first half on record for the S&P 500 going back to 1927. During the first half of this year the S&P 500 never traded up or down more than 3.5% year-to-date (YTD) on a closing basis and finished the first half of the year up a meager 0.20%.
Some market commentators have suggested that this implies the market is topping and getting ready to move into a new bear market. However, history suggests otherwise as this type of low market movements tend to be “pauses that refresh.”
Bespoke Investment Group, in a study they did on June 30th looked at the ten years in which the S&P 500 traded closest to its unchanged level on a YTD basis during the first half of the year and in these ten years the market traded higher on average 6.01% in the second half of the year and was positive in every occurrence. While the study does not guarantee the market will be up in the second half of the year this year, it does suggest the bulls have history on their side.
Given the lack of volatility in the markets one would think that there was little going on in the world. Of course, nothing could be further from the truth and it just goes to show how resilient US markets have been.
Two major developments this year have provided the backdrop for understanding the behavior of global markets. The first was the launch of quantitative easing (QE) by the European Central Bank (ECB) in January where the ECB committed to purchase 1.1 trillion euros through September 2016. The second was the empowerment of the Coalition of the Radical Left Political Party in Greece, commonly known as Syriza. This put Greece on a direct collision course with its creditors and, once again, raised the fear of a possible Greek exit (“Grexit”) from the Eurozone since Greek issues first surfaced late in 2009.
Until this prior weekend it looked more likely than not we would have a Grexit but a last minute agreement was made early Monday morning. Consider Greece faces tough conditions under deal with euro zone:
Euro zone leaders made Greece surrender much of its sovereignty to outside supervision on Monday in return for agreeing to talks on an 86 billion euros ($95 billion) bailout to keep the near-bankrupt country in the single currency…
If the summit on Greece's third bailout had failed, Athens would have been staring into an economic abyss with its banks on the brink of collapse and the prospect of having to print a parallel currency and exit the euro.
"The agreement was laborious, but it has been concluded. There is no Grexit," European Commission President Jean-Claude Juncker told a news conference after 17 hours of bargaining…
Greece won conditional agreement to receive a possible 86 billion euros ($95 billion) over three years. As part of the deal, euro zone finance ministers will discuss on Monday how to keep Greece financed during the time it will need to agree a bailout, but none of the options appear easy, officials said.
With the Greek drama starting to move behind us and hundreds of billions of euros from QE still ahead of us, coupled with low global interest rates and inflation, we should continue to see an upswing in global economic growth. For most of this year economic surprises for major economies have been surprising to the downside though we began to see a bottom in negative surprises in May and we just recently turned to net positive surprises this month (currently at 4.5%) as global growth picks up steam.
Turning specifically to the US we remain of the belief that recession risk remains quite low as too many areas of the economy are moving along with ample momentum, with housing taking center stage. Mortgage purchase applications are up 33.4% over the past six months despite a rise in 30-yr fixed rate mortgages and up nearly 18% over the last year (top panel below) and new homes sold are at the highest level since 2008 as the housing recovery picks up steam (bottom panel below).
Source: Bloomberg
Looking at the US consumer also does not show any cause for concern. Consumer confidence as measured by the Conference Board (red line below) is resting near the upper end of the range over the last decade which bodes well for consumer spending (black line), which is also near the upper end of the last decade. This is encouraging since both consumer sentiment and spending start to decline heading into a recession (see solid blue arrows and red shaded regions) while they are both accelerating in the present case.
Source: Bloomberg
Credit Markets Bent, but Did Not Break
Aside from recession probability analysis the other thing we monitor is the state of the credit markets, which we’ve been paying close attention to lately in light of the Greek drama. Witnessing above average levels of stress in the financial system can provide an early warning of severe market corrections and/or bear markets.
One of our preferred tools of analysis is the Bloomberg US Financial Conditions Index (FCI), which is a composite of many credit spreads. Readings above zero indicate below average levels of stress and readings below zero indicate above average stress in the financial system. Shaded in the image below are negative readings (higher levels of stress) in the FCI alongside the S&P 500. You can see that when financial stress is elevated we tend to witness severe market volatility, recessions, and bear markets. Consequently, we were encouraged that while the FCI began to buckle and approached the zero line it did not break materially below it and is currently experiencing a decent move higher.
Source: Bloomberg
So Bad It’s Good
In light of all the negative media headlines and developments, investor sentiment shows the market continues to climb a wall of worry, a characteristic of bull markets while euphoric sentiment tends to characterize bull market tops. All of the Greek drama, prior Russia-Ukraine conflict, and China growth concerns have pushed investor sentiment to incredibly bearish levels typically associated with short- to long-term market bottoms.
The American Association of Individual Investors (AAII) US investor sentiment poll recently saw the percentage of investors that are bullish drop to the second lowest level since the bull market began! As shown below, these kind of extreme levels of pessimism among investors have marked some of the biggest market bottoms since 2008.
Source: Bloomberg
The best time to turn bearish is rarely when everyone else has, as reflected by investor sentiment surveys like the one above. Adding confirmation to this are current levels of short interest on the New York Stock Exchange (NYSE). Short interest is the number of shares investors have borrowed to sell in the hopes of buying back at lower prices. Eventually the shares borrowed must be paid back by entering the market to buy them. Consequently, when short-interest levels spike you can get a short-covering rally where many wrong-footed investors are forced to buy back their shares, which pushes the market even higher.
Shown below in the bottom panel is the NYSE Short-Interest Level where we’ve seen four short-covering rallies since the bull market began highlighted in green. Not surprisingly, along with near record bearish investor sentiment we have near record short-interest levels and the potential to see a large short-covering rally to push the markets higher.
Source: Bloomberg
Strengthening the results above come from a recent Bank of America Merrill Lynch Fund Manager Survey (FMS) in which they polled 191 respondents who collectively hold 0B in assets under management.
Big Investors Are Holding the Highest Amount of Cash Since Lehman’s Collapse
Results show that cash levels jumped to 5.5 percent, the highest since December 2008, when the world was still in the midst of a major financial crisis sparked by the collapse of Lehman Brothers.
Still, BofAML analysts, led by Chief Investment Strategist Michael Hartnett, figure all that cash on the sidelines is a major buy signal: "When average cash balances rise above 4.5% a contrarian buy signal is generated for equities. When the cash balance falls below 3.5% a contrarian sell signal is generated,"…
The survey also showed the highest percentage of investors taking out protection against a fall in equities since February 2008.
While we are not counting on bearish sentiment and high short-interest levels to lead to a stock market mania, neither are we overly concerned of a severe market correction given the already pervasive gloomy market sentiment, low probability of recession, and below average levels of financial stress. Given the above, our view is that the markets will still continue their upward bias though, as always, we will be on close alert to any changes that may alter this outcome.
