TOM LEE: I see a buy-signal that wins 93% of the time

Between the Greek debt crisis, Chinese stock market crash, and the oil sell-off, it’s been a tough few weeks for US equities.

But Fundstrat’s Tom Lee is still bullish.

“Investors are naturally concerned about fundamental outcomes associated with Greece (Grexit, etc) and spillover impact on the China economy (from the 30% decline in equities),” Lee said in a big 29-page report to clients. “This past week, we saw several measures that point to extreme risk-aversion and hence, a reliable contrarian “buy” signal is generated (with lows established either already or in the next few days). We do not expect any material damage to US fundamentals, and hence, see these contrarian signals as supporting our bullish call for a 2H rally.”

After reviewing five measures of the market, he concluded there was a 93% probability the S&P 500 rallies and gains 9% by yearend.

We summarize the conditions that support his bullish view:

1. The implied volatility term structure has inverted

The VIX term structure just inverted again on July 8, which could be a good thing. Excluding recession years, Lee says, this inversion has happened 11 times since 2004 — and in seven of them, the sell-off ended within days. Three of the other inversions saw longer sell-offs during 2010-2011 because of the impeding threat of a US government shutdown.

According to Lee, returns after inversions are impressive, with markets rallying an average of 6% (in three months) and 10% (in six months), with 100% and 90% win ratios, respectively.

2. US investors are so bearish, it’s bullish

The American Association of Individual Investors’ net percentage of bulls minus bears was at

-12% on July 2, the second lowest level since 2013 (the lowest being -13% on June 11). But, as Lee has pointed out before, extremes in this case usually mean the opposite: “Historically, the AAII survey is a contrarian indicator with a very good track record at the extremes,” Lee wrote in a note last month. “For instance, since 1987, whenever the net bulls reading is this low, stocks have seen a subsequent 6-month rally 100% of the time, with an average gain of 7%.”

3. 1 & 2 together = double bullish

Excluding recession years, there have been five times where the VIX term structure was inverted AND net percentage of bulls minus bears was at or below -12%, as is the case today.

“Each of the 5 precedent periods was associated with an extended rally in the S&P 500,” Lee wrote.

He added that rare occurances resulted in rallies averaging 6% (over 3 months) and 9% (over 6 months) with a 100% win-ratio.

4. The CBOE put/call ratio reached 1.13

The ten-day average of the Chicago Board Options Exchange recently rose to 1.13, which Lee calls a “reliable buy signal.”

“This implies demand for downside expectations (put) exceeds upside, and hence, is a contrarian buy signal at the extremes,” Lee wrote. “Since 2011, there have been 9 instances where the Put-call ratio spiked [and] markets rallied 8 of 9 times.”

5. The long-term yield curve steeped in the first half of 2015

In the first six months of this year, the spread between 30Y and 10Y treasury notes — known as the long-term yield curve — steepened significantly. This is an unusual occurrence six years into an expansion.

Looking at the 13 times that the LT yield curve has steepened in the first half of the year amid positive market gains, markets further gained 85% of the time, with an average gain of 9%.

6. The S&P is catching up to Germany’s DAX

Germany’s DAX is an index of the country’s 30 largest companies (think Siemens, BMW, Deutsche Bank, etc.) The DAX is outperforming the S&P 500 YTD by 1,500bp — the 3rd biggest triumph since 1959. But, as Lee also pointed out last month, US stocks are “due for a catch-up trade.”

Lee says that whenever the S&P has underperformed the DAX by so much, it catches up by rallying through year end. The historical average gain is 12% with a 100% win-ratio, excluding recession years. He sees a strong sign of a better second half of the year for stocks

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