By the close of business last Monday, developed equity markets could have been characterised as oversold on a short term perspective, and investor sentiment had certainly become a lot less complacent compared to year end. The chart below of the Eurostoxx 50 Index shows how, by the start of the week, the index was at the bottom of a simple trading envelope (blue lines) indicating a bounce was possible. Furthermore, momentum had reached levels that would also be consistent with the possibility of at least a relief rally.
The next chart below shows the S&P 500 and the bullish Index from the National Association of Active Investment Advisers. Since the end of the last year, the bullish index has dropped from near 100 to near 50. Clearly, the recent declines in the equity markets have resulted in the market becoming less complacent, and yet this sentiment indicator (along with others we use) has not even declined to levels seen after the mild corrections last year. All we can really take from the majority of our sentiment indicators at the moment is that they would probably not impede a market rally from the oversold levels reached earlier in the week, and yet at the same time do not indicate panic and capitulation by investors.
Now that we have established that markets had become short-term oversold and sentiment had become a lot less complacent, where do markets go now?
Our longer term analysis continues to indicate that the potential upside is limited and the risks of a meaningful bear market are growing. That said, in the short term, markets are finely balanced. In the chart below of the S&P 500, we have again shown a trading envelope around price and a simple momentum indicator. We have also noted that the 1800 area saw a lot of activity late last year, and again last week. If the rally that began this week is going to fail, we believe that we are fast approaching an appropriate technical level for such a failure, not just in the US but also in Europe. If the 1800 area is broken through on the topside, then the market holds the strong potential for further gains.
Last week was a busy week for data and central bank meetings. It appears to us that the recent round of economic data, especially in the US, has been below expectations (Citigroup Economic Surprise Indexes support this view). Of course, many will blame the weather but the simple fact is that growth (and corporate earnings) is likely to be less than thought only a few weeks ago. At the same time, the noises coming out of the FED are that they will continue their policy of reducing QE steadily (let’s assume US$10 billion reduction at each meeting) and it would take a big negative surprise for them to be blown off course. We also know that the Peoples Bank of China (PBoC) and the ECB are not looking to add liquidity at the moment. So, in simple terms, the market can expect less liquidity and not so much growth. This does not seem like an appetising mix for equity investors, especially after the huge re-rating of last year and with valuations arguably at the most expensive historic extremes aside from the bubble years of the late 1990's.
To conclude, markets are rallying off an oversold condition and have quickly approached levels that appear to be resistance. We believe that in the very short term, markets are finely balanced, and so we are taking a neutral stance at the present juncture. Long term, equity markets simply do not look attractive especially with the Fed exiting their extraordinary policies. From our current neutral stance, we continue to believe that the risks lie on the downside and we are looking for technical signals in the next week or two to become bearish again.