Michael Purves Chief Global Strategist Head of Equity Derivatives Research (203) 861-7725 [email protected] May 19th, 2014 How to Love the Unloved Rally: SPX Calls for the Quarter Summary Equity market valuation can hardly be described as a bargain and a flatter yield curve continues to hover over equity sentiment. High momentum/high valuation names continue to not trade well and leadership is confined to a narrower group of companies. None the less, key equity indices continue to edge higher, making new life time highs in the process. It may not feel right, but we think that a beta chase into quarter’s end is increasingly likely. Many funds have adopted a more cautious stance and many are trailing the SPX this year. If the broader market is able to keep going higher (which we think it will), we suspect a “beta grab” can easily develop – a patterns we saw play out in November and December. This condition may present difficult situations for managers concerned about relative performance. Correlations are low among stocks. Rapidly shifting exposure around may present significant challenges in a market defined by rapid sector and stock rotation. A simple answer is to spend a modest amount of premium on a “reverse hedge” through purchasing upside calls on the market, taking advantage of record low implied call volatility levels for calls. The Trade Implied call volatilities for slightly out of money SPY calls with June end of quarter expiry are trading at post Great Financial Crisis (“GFC”) lows. We recommend the SPY $191 strike June quarterly calls, currently trading at $1.26 (reference price $188.26, i.v. = 9.8, d.m. = .33). Key Points. Catalysts between now and quarter’s end are relatively light, but we think enough dynamics are in place to support a further rally during the balance of the quarter. Consider:  Market Sentiment Levels at “Pale Green”. Bullish sentiment is reasonably strong, but far from the froth zone:  Investors Intelligence bull less bear spread has declined from 36.1% last week to 35.7% this week. These levels are roughly ½ between the December, 2013 extremes and the February, 2014 lows.  MarketVane. Bullish sentiment on SPX futures is currently at 62, a bullish number but far below the high 60 levels achieved in late December.  AAII. AAII Bull Less Bear readings are actually negative per last week, and continue to trend lower (next reading out tomorrow). Retail volumes appear to have started coming in, but clearly this investor base is coming to the party (understandably) cautiously.  Flows and M&A. While flows into domestic equity mutual funds went negative in the prior two weeks, they were positive last week. More importantly, as our colleagues at Leuthold point out, YTD inflows are positive and more so than any year since 2006. Domestic M&A volumes are up 84% over last year; a key new pillar in the equity supply/demand equation.  Earnings. Despite the difficult weather in Q1, companies (including small caps) were able to eke out revenue and earnings upside surprises more often than not.  SPX. Nearly 76% beat on earnings and 53% beat on revenues this season (457 of 500 of the companies have reported). The average earnings beat was 6.3%, the highest average beat in two years. Q/O/Q EPS growth is trending towards a minimum of 6%, an impressive beat given the weather issues in the quarter.  Small Caps. Within the Russell 2K, 51% of the companies which have reported have beaten on earnings while 53% have beaten on earnings.  Economic Conditions Trending Better Than Expected. Aside from housing, several economic metrics are trending better than expected; the Citibank surprise index shows an aggressive rally off February lows (Chart 1). Additionally, consider:         Substantial expansion of Commercial and Industrial loans, suggesting credit growth and potential an increase in capital expenditures Capital goods orders growth above expectations. Durable goods orders have demonstrated upside momentum. Capacity utilization levels almost at the key 80% level. CEO confidence surveys are have been trending better and momentum is gathering. The NFIB small business optimism index made post Great Financial Crisis (“GFC”) highs this week. Consumer sentiment continues to strengthen, against a backdrop of higher gasoline prices. Standout payroll adds in April. (Please see our note “Stealth Rally in Capital Expenditures” of April 29th for details on many of these metrics).  Small Cap Valuation Has Reset to Long Term Averages. Per Bloomberg consensus estimates, the forward P/E on the RTY has come in from 30 at December 2013 to 24.6 currently (the peak this year 26.5 in early April). The 10 year average forward P/E for this index is 24.4 when one strips out the unusually elevated P/E’s from 7/2008 – 12/2009. These valuations can hardly be described as a bargain given the nominal GDP growth environment, but they are not exceptionally stretched as they have been over the last six months.  Inflation – Bottoming and Perhaps the Worst is Behind us. Expectations for inflation have, understandably, been pounded into the ground, and for some time now. However, we think that is looking increasingly likely that inflation has bottomed, and that inflation metrics are likely to come in somewhat higher in the coming weeks. We are still far below Fed target rates, and likely will be for some time. However we think at the margin the capital markets have been overly complacent on this issue (as we can see in the extreme strength in the back end of the Treasury market despite tapering). Higher inflation should be equity friendly/bond unfriendly scenario as a re-steepened yield curve and (presumably) higher flows out of bonds into equities add a further leg of support. 2 Several factors are suggesting inflation metrics will start trending higher: o PPI final demand printed at 3 year highs this week. o Wage Inflation – Underemployment Is Actually Getting Better. While wage inflation posted nil growth in the last NFP report, the bigger picture is encouraging. There are no questions that there are long term structural deflationary trends in place. However, there are some encouraging signs. The U6, or underemployment rate, a key component for labor slack, has decreased from the very high 17.3 in 2010 to 12.3. We are now not too far away from the 8% to 10% range which defined 2003-2006 period, a period of healthy overall labor conditions. It strikes us that the hardest work is behind us in reducing this slack component of the economy. Above average job gains such as we had in the last note should help, and ultimately in other words the hardest work in reducing this number is behind us. As more jobs are added, this should help take out slack from this part of the employment pool. o JOLT Quit and Hire Rates. We are also encouraged by quit and hiring rates which continue to rally to post GFC highs. o Capacity utilization at critical level where CEO’s start worrying about inflation (and hence start adding capacity). o Forward inflation expectations. Implied forward inflation expectations have jumped up nearly 20 bps since early April (Chart 2).  Technical Considerations. The big picture here is that the large cap bull trends are intact and the more problematic charts (small caps, tech) are starting to stabilize.  Large Caps. Equity markets are still in a bullish stance. We have a seen a sequencing of new life time closing highs: the Transports made their life time high on April 23rd, followed by the Dow (April 30). The SPX made a fresh intraday and closing highs this week.. The bull trends in these indices may be tired, but the charts are still pointing higher. It should be noted that the breadth of the market is not strong and leadership is highly concentrated.  Small Caps. The question remains – will the blue chips/large caps lift up the small caps/high dividend stocks or vice versa? The Russell 2k is at important near term and long term support levels (Charts 3 and 4). Given the strength in the large caps, “breaking” the Russell down will require a major risk-off event at this time. The reversal to the upside earlier last week was impressive and the weekly close held key support. Some horizontal consolidation for this index seems like the likely path. We are also seeing a notable decrease in the RVX-VIX spread suggesting the worst is over for the small caps.  Nasdaq. The NDX has been recovering from its April sell off and has been able to poke above its recent highs at the ~3,600 level. This has helped negate the head and shoulders pattern that was becoming apparent. Similar patterns are echoed on the CCMP. Chart 5.  High Momentum. Even our high momentum index is showing some level of near term stabilization, as can be seen in the daily RSI’s and MACD which are trending slowly upwards off their oversold conditions (Chart 6). However, this chart, and many of the momentum names, still appear highly vulnerable to continued selling and care should be taken in this space. 3 Note: this high momentum index includes flsr, tsla, nflx, p, pcln, crm, znga, yelp, grpn, and amzn (equally weighted).  Equity Volatility – not as complacent as the VIX might suggest. The VIX has reset to the 2013 complacency lows of 12 to 12.5 range. These are clearly low levels, but we believe equity volatility is not as complacent as it first appears. It is also relevant that cross – asset volatility levels are much closer to their life time or multi-decade lows than the VIX is relative to its long term lows (Table 1). In this context the VIX is actually suggesting that it is not as complacent as it might appear. As noted above, the RTY volatility has been quite elevated (the spread of RVX to VIX at 2011 risk-off levels) – illustrating the heightened volatility within the market. Table 1. VIX Time Series Start Date Treasuries (MOVE) 1/5/1990 4/8/1988 Euro 1 Month Implied Vol. 1/1/1999 JPY 1 Month Implied Vol. 12/8/1995 Gold 1 Month Implied Vol. 6/14/2002 WTI 30 day Realized Vol. 05/07/04 High Low Current Level Average 79.1 9.5 12.1 19.9 264.6 49.0 56.1 99.9 27.3 4.7 5.3 10.3 35.4 5.9 6.2 10.9 57.6 10.0 13.5 19.1 95.3 16.4 17.6 33.1 Current Level % of Hi/Low Range 5.6% 2.9% 2.8% 0.9% 7.3% 1.6%  Flat Yield Curve Is a Concern If 2013 was defined by the taper, the flattened yield curve continues to hover over equities this year. A sell off of the long end of the curve will certainly be advantageous to equities and should enhance equity inflows (great rotation gets back in gear). It is important to recognize that the yield curve has been at multi decade wide levels (meaning back end relative to front end had been at record wide levels). Given the discussion on Fed policy has shifted from QE to the front end, this will likely continue to be an issue for equities to struggle through. However, as noted above, a pick-up in inflation data, however, should re-steepen the yield curve. Chart 7. 4 Chart 1. CitiSurpise Index Chart 2. 5 Year Implied Forward Inflation Expectations 5 Chart 3. RTY Daily Chart 4. RTY Monthly 6 Chart 5. NDX Daily Chart 6. High Momentum Index, RSI and MACD 7 Chart 7. 2/10 Yield Curve Disclaimer: This publication is prepared by Weeden & Co. LP’s (“Weeden”) trading department, not its research department, and is for informational purposes only. 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