Summary
- Short-term indicators reaching levels often associated with interim peaks or periods of consolidation
- Markets should pause until big news later in the week from ECB and May’s Job report
- If above disappoint, healthy level of bearishness from hedge funds suggests downside risk may be limited
- Bulls on same side of fence as commercials, who are the most bullish they have been in years
The S&P 500 continued to power to new highs last week and is now pushing closer to the 2000 mark. That said, the S&P 500 moved into short-term overbought territory and is likely to either move sideways or pullback to its breakout (1900) before moving higher as it catches its breath. Shown below are a few of my short-term timing indicators, which have reached levels associated with short-term tops.
Source: Bloomberg
In addition to the short-term overbought nature of the markets likely to cause the markets to cool this week, we have big news later in the week from the Thursday ECB meeting and Friday’s release of the May jobs report. Investors aren’t likely to make any investment/trading decisions prior to these big events and currently speculation continues to build that the ECB will act on Thursday as Europe continues to face deflationary forces. Yesterday we were treated to German inflation data for May which came in at a 0.6% annual rate, the lowest level in four years and below all of 21 economists surveyed by Bloomberg, with the median estimate at 1%.
Source: Bloomberg
Outside of the 2008-2009 global recession, Germany’s inflation rate is at the lowest level in 15 years.
Source: Bloomberg
Also surprising to the downside was Germany’s manufacturing PMI, which came in at 52.3 under all 27 estimates (see below) as the German economy is weaker than most economists had expected for May. Given Germany is the biggest holdout to stronger monetary easing by the ECB and with current incoming data from May as weak as it is, there may be less opposition for the ECB to act aggressively on Thursday.
Source: Bloomberg
If the ECB doesn’t act aggressively on Thursday they will be treated to even more support for aggressive action at future meetings as opposition from Germany should continue to weaken as its economy continues to slip for the remainder of 2014. Evidence for a weaker German economy comes from looking at M1 money supply for the Eurozone, which leads the German PMI manufacturing index by several months and suggests we may see a sub 50 reading (contraction territory) for the German manufacturing sector by late 2014.
Source: Bloomberg
The other big event this week is Friday’s release of May’s change in US nonfarm payrolls. Currently the average of 85 estimates provided to Bloomberg calls for payrolls to increase by 215K and it will likely take numbers below 193K or above 237K (+/- 1 standard deviation) to elicit a big reaction from the markets.
Source: Bloomberg
Any aggressive action out of the ECB on Thursday and/or a strong jobs report on Friday are likely to send the markets to new highs as greater global financial liquidity and more evidence of a strengthening US economy quell concerns over first quarter's negative GDP reading.
However, should the ECB underwhelm and/or we receive a weak employment report, I wouldn’t expect a deep selloff in the markets given how bearish sentiment is, particularly coming from hedge funds and active managers. Last week, in a note to institutional clients, Morgan Stanley observed that hedge funds are the most net short futures on the Russell 2000 since July 2008, with hedge fund gross exposure near multi-year lows. Confirming the data from Morgan Stanley is BOFML’s Hedge Fund Monitor last week that showed speculators have moved to a net short position in the S&P 500. Shorts on the Russell 2000 are the highest they have been in two years while long positions in the NASDAQ are the lowest in one year. Also, according to BOFML, their Fund Manager Survey for May showed cash levels at a 2-year high.
The level of bearish sentiment out there reached levels that marked the bottoms of 2010, 2011, and 2012 when viewing short interest on the New York Stock Exchange (NYSE) (see green shaded region). When short interest declined from these elevated levels the markets embarked on strong legs higher as shorts covered and added to the buying stampede.
Source: Bloomberg
While large speculators and hedge funds are the most bearish they’ve been in years, what should be encouraging to the bulls is that, when viewing the commitment of traders (COT) report, commercials are the most bullish they have been in years (Note: commercial traders are widely regarded as the “smart money” while large speculators are considered the “dumb money.”) Given the track record of commercials increasing their net long exposure to the Dow and the NASDAQ at market bottoms (see green boxes below) while decreasing long exposure near market tops, I’d tend to side with the commercials who are currently bullish.
Source: Bloomberg
Summary
Markets entered this week at a short-term overbought condition and are likely to pause. Adding support for a pause are the two big news events that come later in the week: the ECB meets on Thursday and we are treated to May’s jobs report on Friday. Germany has remained the biggest opposition to large scale monetary easing by the ECB, although a weakening German economy and inflation rates approaching negative territory may put some pressure on the Germans to soften at the edges and allow the ECB to act more aggressively at this coming Thursday meeting. On the domestic front, estimates for May’s jobs report are for a monthly gain of 215K payroll additions, down from April’s 288K growth pace.
If either or both the ECB meeting and the jobs report underwhelm expectations, we are likely to see some weakness in the markets as would be expected. However, given the level of bearishness by hedge funds and with BOFML’s Fund Manager Survey showing active managers' cash levels at a two-year high, there is a great deal of healthy institutional bearishness that suggests markets continue to climb a wall of worry. Also, given how commercial traders—i.e. "smart money"—are positioned, I’d tend to side with the bulls in not expecting a major top anytime soon.
