Over the past week our core market health indicators continued to fall. Our measures of quality and trend fell far enough to join the economy in negative territory. Our measures of market strength fell substantially as did our measures of risk (meaning the market is more risky). Our indicators are telling us that there is a high likelihood of a pause in the market and that risk to long stock positions is rising. It could play out as a very choppy slow uptrend, an extended sideways move, or a pullback in price. As you know we don’t try to predict the future, rather we try to align our portfolio with the health of the underlying market.
We changed our portfolio allocations as follows. Both of our Long / Cash portfolios are now 40% long and 60% cash. Our Long / Short (or hedged) portfolio is now 70% long and 30% hedged. Our longs still consist of stocks that we believe will outperform the general market during sustained up trends. However, we’ve trimmed some of the high fliers and stocks that have more beta (are more volatile than the market and more prone to suffer during a down trend). Our short is a simple short of the S&P 500 Index (short SPY or long SH). If the market continues higher from here our current portfolio construction(s) will allow us to participate a little. If the market falls we’re comfortable that most of the gains from early January will be protected.
Our Twitter Sentiment indicator for the S&P 500 Index (SPX) continues to paint lower highs over the past week. We’re seeing a pattern that shows traders have less enthusiasm on up days and more negativity on down days. Large percent up days are only getting neutral sentiment readings in the +6 or + 8 range. While down days garner fairly negative readings in the -15 area. This indicates that traders are somewhat skittish and their interest in getting short or protecting gains outweighs their desire to take on more risk at these levels. The volume and intensity of tweets on the down days is further evidence that any weakness brings rising fear.
Smoothed sentiment rallied with the market over the past few weeks, but was turned back convincingly at the zero line with the weakness on Wednesday and Thursday. Price on SPX is 8 points higher than when we got our first warning from smoothed sentiment on 1/29/13, however, sentiment is much lower. This indicates that the recent drop in price is causing market participants to become cautious.
Last week SPX pushed just above the Twitter resistance level of 1525. As it rose to 1530 we got a few tweets calling for higher prices. However, the market quickly reversed. Its inability to hold the 1525 level on a retest brought the selling we expected that carried back to the 1500 Twitter support level on SPX. Friday saw the market bounce at that support level and we’re now in the middle of both support and resistance. The bulls need to hold 1500 and the bears need to keep prices below the 1525 to 1530 level to continue the fight. A move out of the recent range will give us a winner and a direction.
One thing of note is on the test of the 1500 level on SPX we started to see a very large number of tweets calling for a fall to the 1460 to 1475 level. Most of the tweets were near 1470 so we’ll keep that as our lowest support level. The rising number of traders targeting prices below the market is one more indication that bearish sentiment outweighs bullish sentiment.
With smoothed sentiment still below zero and continuing to negatively diverge from price we don’t expect an immediate run to significantly higher levels. Our expectation is that any further rally will experience some headwinds and short selling if it gets into the 1525 or 1530 area. The number of tweets calling for lower prices should also act as a magnet. As a result, we expect to see some sloppy action or weakness in the week ahead.
Both market internals and sentiment suggest that caution is warranted. This is a time to evaluate your portfolios and determine your risk tolerance. For the moment it appears that the market wants to pull back to the 1470 level. However, 1500 has very strong support so that level must be breached first. We expect (but are not predicting) weakness in the short term, but we’re watching to see how the market internals react to any bounce or failure before drawing any conclusions for the intermediate term.