Bulls vs Bears: US Equities

Introduction 

When it comes to investing in equity markets, one of the most important rules is to invest at the right time. So what does that mean? Well shorter term traders will argue that timing can be when the RSI goes below 30 oversold, while some traders will argue that you need to follow shorter term cycle patterns and finally others will argue that you should buy into equities when certain moving averages cross above other longer term ones, etc etc. 

I would argue that the most important time to invest into equities is at the beginning of an expansion within the business and investment cycle and the most important time to be out of equities (especially during secular bears) is at the beginning of a contraction within the business and investment cycle. The only problem with all of that is that bulls and bears tend to debate when the business cycle is about to change directions, and many get it wrong over and over due to false signals. So let us discuss as many topics as possible in point form for both the bullish and bearish sides.

Bulls vs Bears: US Equities

• Bulls say that the current business cycle is still positive and growing. After all, the most important evidence is the fact that US GDP is still expanding on a quarterly basis, Industrial Production is still growing at a very healthy rate and while jobs growth is very slow, it is progressing with the recent data release showing a net gain of 160,000 jobs (chart above). Other data points worth mentioning for the bullish side are the fact that company capex remains strong and retail sales are positive. Bulls say, all of this points to a slow muddle through economic activity as the United States is the best house in a bad neighbourhood and is evidently de-coupling from a European recession.

• Bears say that while the current business cycle is expanding, the rate of growth is now at stall speed (chart above). Over the last six GDP quarters, five of them have been below 2%. Bears say that every time this has occurred since at least the 1950s, the US has always entered a recession. Furthermore, bearish points include the fact that payrolls are a lagging indicator, as job cuts only occur once CEOs realise we are already in a recession. Bears also argue that retail sales have now dropped for three months in the row. Over the last 60 years, this type of a statistic has only occurred 27 times (1 in 50 event), and 25 out of those 27 times have occurred either during a recession or a quarter before one began. Bears say, stall speed can only be maintained for so long until a recession starts and de-coupling is a very dangerous word last used in 2007 prior to a global bear market.

• Bulls say that the current manufacturing cycle slowdown, as seen in the chart above with the US ISM chart, is very similar to the previous two in the summer of 2010 and the summer of 2011. All we are going to see is seasonal summer dulldrums and slight disappointment in growth, before we see another pickup into years end.

• Bears say that a manufacturing slowdown is what we witnessed last year during the summer months. If the recovery was real, then the overall global manufacturing (heavily weighted towards the US) would have recovered already. The fact is, bears argue, that we are now entering a manufacturing recession around the world.

• Bulls admit that recently data has disappointed, but remain optimistic that it is about to pick up again. They point to the Citigroup US Economic Surprise Index (chart above) and say that on a mean reverting basis, data should start beating expectations as economists have become too bearish. 

• Bears say that previous data slowdowns mainly occurred in the Developed Markets, which were growing very slowly anyway. Similar occurrences can be seen in late 2007. On the other hand, Global Emerging Markets (GEMs) have been the pillar of strong growth and the major consumers of commodities, since the recovery began in '09 and bears argue that a slowdown in this part of the world is now a very worrying signal.

• Bulls say that the stock market is undervalued based on the most simplest of all tools - the Price to Earnings multiple ratio, which is currently trading well below its five decade average. They also argue that based on common sense, stocks are undervalued by at least 12% or more (chart above), because earnings are now sitting at record high levels. Therefore, stocks should be trading at 1,600 or even higher. Finally, bulls say that earnings continue to beat expectations in general and this is a positive for stock prices.

• Bears say P/E multiples expand during secular bull markets (1982 - 2000) and contract during secular bear markets (1966 - 1982 and currently from 2000 onwards). Therefore, further P/E contraction can be expected even if earnings rise higher. Bears also argue, as can be seen in the chart above thanks to short.com, that CAPE 10 (cyclically adjusted price to earnings ratio) places stocks in very expensive territory. Finally, bears say that the Gross Profit Margins have now peaked and are falling and if that wasn't bad enough, revenues are also disappointing expectations too.

• Bulls say that the US stock market is the best house in a bad neighbourhood when it comes to performance (chart above thanks to yardeni.com), with a better fundamental position than Europe and Emerging Markets, and that is why the S&P is experiencing huge outperformance. Furthermore, bulls say that we are currently in a US presidential cycle and that stocks should be able to post decent gains into year's end.

• Bears say that de-coupling in equity markets does not last. They argue that in early 2008, Emerging Market equities gave de-coupling a shot for awhile as US equities peaked, but they eventually caught up on the downside. This time around, US equities will be catching up on the downside too. Besides, the bad seasonal period for equities is now upon us, say the bears.

• Bulls say that the mood in the current market environment is pessimistic and this is best seen with the chart above showing that individual retail investors, as tracked by the AAII survey. The chart shows extreme bearish readings over the last three months, which is a strong buy signal. Furthermore, bulls show that various other sentiment surveys are quite bearish and that stock analysts are in total panic mode (chart #1 & chart #2). Also to note is the fact that retail money continues to sell stocks at the expensive of bonds and that is another positive contrarian signal. Finally, if all of that wasn't enough proof that we are going to rally much higher, bulls say that hedge funds are currently underexposed to US equities, so all in all it is time to buy and not sell.

• Bears say that surveys are less relevant than actual exposure, because it is the old "who said what versus who bought what" argument. Bears state that cash levels are extremely low in all major indicators from rydex mutual funds (chart above) to pension fund allocations and retail money market funds. Bears also claim that while AAII sentiment survey show an "opinion" of low bulls, the AAII asset allocation survey shows the "action" of very low cash levels. Furthermore, bears claims that the AAII survey isn't confirmed by other surveys, including the very low level of bears in the Investor Intelligence.

• Bulls say that as volatility remains low and financial conditions remain calm, equity markets can keep trending higher from these levels. Furthermore, the Junk Bond market which is a great barometer of overall risk, is not pricing in a recession nor a bear market (chart above). Finally, bulls state that from a technical perspective, Junk Bond prices look like they are in a healthy uptrend, which is pro-risk and a definitive positive for their equity counter-parts. Also to note is the fact that the VIX can stay very low for a prolonged period of time, according to the bulls.

• Bears say that the low volatility readings have been a contrarian indicator ever since the Global Financial Crisis started in late 2007, and currently we are in the danger zone again. At the extremely low levels of 15 on the VIX, bears say it is time to short equities with a potential to see lower prices in the months and quarters ahead. Finally, bears say that Junk Bonds tend to correlate very heavily with the VIX, so one shouldn't pay much attention to it as a leading indicator. Furthermore, Junk Bond ETFs are experiencing record inflows which from a contrarian perspective could mean lower prices ahead.

• Bulls say that the current trend is up. It doesn't matter what any other indicator says, because the most important indicator of all is the price. It has made new highs in 2012, remains above the 200 day moving average (basic uptrend / downtrend gauge) and is also currently trending with higher highs in the short term too. Furthermore, bulls say that the percentage of stocks above 50 day moving average is around 75%, which is quite healthy for an uptrend, while not overbought or extreme. Also to note is the fact that McClellan Oscillator and the Bullish Percent Index are not overbought either, so from an internal breadth point of view, a correction is most likely not due. Finally, the NYSE cumulative AD line is making new highs, so bulls claim it is only a matter of time until the S&P 500 follows.

• Bears say the equity price is approaching the major supply sell zone (technical resistance) from April 2012 highs, but this time around the internals are rather negative. Bears say one should consider that less than ⅔ of all stocks within the S&P are trading above the 200 day moving average (chart above). Bears also say that the percentage of stocks making new highs versus new lows is very low and is bearishly diverging with the current rise in price, advising a cautious outlook. Dow Theory shows a major non-confirmation between Industrial stocks making new highs, while economically sensitive Transports aren't following, so bears claim it is only a matter of time until the divergence is played out to the downside. Finally, bears claim that whenever cyclical sectors have under-performed the S&P by this much, it has lead to at least an intermediate top and a correction.

• Bulls say that Dr. Bernanke stands ready to act as early as the Jackson Hole meeting at the end of this month. Further quantitative easing (Fed balance sheet expansion a.k.a. printing of money) and other additional stimulus measures should support the US economy and risk assets through the current slowdown patch until the natural growth cycle picks up.

• Bears say that while Dr Bernanke will eventually act, he might not act immediately because of the US elections approaching. Furthermore, bears say Bernanke understands that expectations of inflation are currently too high (chart above shows 5 Yr break Evens need to approach at least 2%) and there are currently no risks of deflation as Core CPI is above the Feds target. Finally, bears say that the recent Non Farms Payroll report takes QE3 off the table, so lower prices are possible.

So... when it comes to the medium term time horizon (months to quarters), please let us know what you think on the direction of US equities in a survey poll below:

Survey Poll

After several days of voting, over three hundred traders and investors have spoken toward the first article on Bulls vs Bears debate, with a topic on US equities. About 30% are currently bullish over the medium term time frame, overwhelming 50% are bearish and finally 20% or so are neutral. Another way to look at this is to state that 30% would be buyers, expecting high prices; while 70% are neutral or would be sellers, expecting lower prices. 

I guess contrarians would argue that any polls majority is usually wrong, but this one will be a perfect test. In coming months, we shall truly see how smart and wise the underlying reader base of Short Side of Long really is, and will they be classified into smart money or dumb money. Stay tuned...