No Trend Uniformity

As John Hussman points out in his most recent weekly missive, the stock market currently reflects all the characteristics observed near previous major market peaks. Apart from the more obvious ones, such as overvaluation and lopsidedly bullish sentiment which have been with us for some time, the market’s internals continue to deteriorate. This makes the current situation especially dangerous. As Hussman notes:


When extreme valuations and lopsided bullish sentiment are joined by deterioration in market internals, one faces an environment that couples compressed risk premiums with increasing risk aversion. Throughout history, severe market losses and crashes have nearly always been the result of an upward spike in previously compressed risk premiums.”


(emphasis added)


trader_1963744bPhoto credit: Alamy


The deterioration in market internals is e.g. evident in new high/new low ratios that are inconsistent with a market making new highs, and a growing divergence between prices and advance/decline statistics. Also, an ever smaller percentage of stocks remains above important moving averages. Below is a chart depicting several of the most widely followed market internals (high/low percent, advance/decline line, S&P 500 stocks above 200 day and 50 day EMA).

What this essentially tells us, is that capitalization-weighted indexes are held up by an ever smaller number of big cap stocks. A the time of writing, a strong short term rebound in the stock market is underway. However, the underlying problems with trend uniformity and internals depicted below remain in place.


1-InternalsA number of important market internals – click to enlarge.


A large proportion of the stocks holding up the cap-weighted indexes are technology stocks, which is actually an additional warning sign. At the peaks of 1998 (ahead of the Russian/LTCM crisis), 2000 and 2007, a handful of “horsemen” from the technology universe were the very last stocks to make new highs – it seems to happen every time.

A major reason for the deterioration in internals is the economic weakness currently spreading in China, coupled with malinvestment on a grand scale in the commodities sector over previous years. This combination is putting pressure on commodity prices and the energy and materials sectors have entered bear markets as a result. These two sectors together currently represent 15% of the market capitalization of the S&P 500 Index. Transportation stocks have begun to sag as well and have been in a down trend since the end of last year (see “Transportation Sector in Trouble” for details on this).

Lately, the weakness has however spread further, as industrial stocks have begun to join the decline as well. In order to provide an overview, we have picked the six charts below, which show the weakest sectors and the strongest sector (technology) compared to the SPX.


2-Sectors-AXLE (an ETF that serves as a proxy for energy stocks), XLB (materials ETF) and the Dow Transportation Average. Energy was the first major sector to enter a bearish trend (gold and coal have been in bearish trends for longer, but they are tiny sectors) – click to enlarge.


3-Sectors-BXLI is an ETF of industrial stocks – this sector has begun to deteriorate as well now, although it still remains stronger than the first three sectors shown. The strength in big cap technology stocks has helped the S&P 500 to remain in a sideways trend so far, while the Nasdaq Composite is actually still not too far off an all time high – click to enlarge.


It should be noted to this that once materials and energy have declined a lot, their weight in capitalization-weighted indexes will decrease and they will exert less and less influence on the overall market’s trend. Cap-weighted indexes have a built-in bias – the bigger a company’s capitalization becomes, the more it will influence the index and vice versa. This is one of the reasons why the stock market’s performance rarely reflects the performance achieved by most individual investors and fund managers, which is often significantly worse.

Over the past three months equal-weighted indexes – which one can think of as reflecting a “well diversified portfolio” better than a cap-weighted index – are markedly underperforming their cap-weighted brethren. Below is a chart of the Guggenheim equal-weighted S&P 500 ETF (RSP) vs. the SPX illustrating the situation:


4-RSP vs. SPXRSP has begun to underperform SPX by putting in lower highs and lower lows – click to enlarge.


A Major Recession Warning

As we have often pointed out, GDP is not exactly a very useful economic indicator. Not only does it include what is ultimately wasteful spending such as e.g. government spending, it also suggests that a trade surplus or deficit is a measure of economic well-being and most importantly, it simply excludes the vast bulk of the economy’s production structure.

Dr. Mark Skousen has developed an index based on the gross output data of industry, which the government has thankfully begun to publish at greater frequency and with a smaller lag time (once upon a time, these statistics were only published every two or three years and were usually out-of-date when they finally did come out). As Dr. Skousen reports, the most recent release of gross output data for Q1 2015 suggests that the rate of growth of business-to-business spending continues to decline sharply. This is normally a quite serious early recession warning. In fact, B-to-B spending is already declining in nominal terms, and only the application of the (highly questionable) “price deflator” leaves it above the waterline in real terms. Dr. Skousen writes:


“Gross Output, a broader measure of U. S. economic activity published by the Bureau of Economic Analysis, continued to slow into the 1st quarter of 2015, confirming tepid growth in the economy and a potential recession. According to today’s BEA release, real GO advanced at an annualized rate of only 0.7% to $31.0 trillion by the first quarter of 2015, compared to 5.2% in the 3rd quarter and 2.6% in the fourth quarter of 2014. The downward trend in the economy continues. In nominal terms, GO actually fell 1.1% but price deflation was so strong that GO increased in real terms.


(emphasis added)


5-B2B IndexDr. Skousen’s B2B Index of US business spending (red line) vs. consumer spending (blue line).


As you can see from the chart above, there has been a serious deterioration in business activity. It is important to keep in mind in this context that the widely reported assertion that “consumer spending is 70% of economic activity” is simply wrong. It may be 70% of GDP, but it represents at most 35 to 40% of all spending in the economy. Business spending is the far more important statistic. Dr. Skousen also provides a comparison chart that is making this abundantly clear:


6-Business vs. Consumer spendingThe nominal value of US business spending vs. US consumer spending (gross). Business spending is about twice as large as consumer spending – and it is turning down rather noticeably.


This is to our mind the strongest recession warning that has appeared in recent weeks and months. Other US economic data continue to show a tepid economy, but not one that is in imminent danger of falling into recession. The gross output data are however quite concerning in this respect.


Money Supply Growth

What makes this especially interesting is the fact that US money supply growth in terms of the broad money supply measure TMS-2 remains quite brisk at 8.4% annualized. We have long argued that the “recession threshold” is probably higher this time than it once used to be, as the economic recovery has been extremely weak so far. When not even major monetary pumping can create the illusion of strong growth anymore, it usually indicates that the economy’s pool of free capital, a.k.a. the pool of real funding, is in grave trouble.

The introduction of additional money into the economy can of course never produce genuine economic growth. In fact, it achieves the exact opposite. Central banks cannot magically produce real capital, but by incentivizing a misdirection of existing wealth into unprofitable ventures (the survival of which as a rule depends on continued loose monetary policy), they can help to create “activity” which is then measured by assorted aggregate economic statistics and masquerades as “growth”. In reality, a great deal of this activity simply consumes scarce capital.


7-Money TMS-2The annualized growth rate of the broad money supply measure TMS-2 – since “QE3” has ended, it has oscillated between 7.4% to 8.7%, as commercial banks have taken the baton from the Fed and have expanded the creation of fiduciary media, primarily by granting commercial and business loans – click to enlarge.


While the annualized growth rate of TMS-2 has remained within the sideways channel established after the “taper”, there are some signs that money supply growth may be about to slow down more sharply. The narrow money gauge M1, which is closely aligned with TMS-1 (or money AMS, for “Austrian Money Supply”) has seen a notable reduction in its growth rate lately – and it often leads broader measures such as TMS-2:


8-M1The growth rate of narrow money M1 has already declined below the “shelf” and is now at 6.44% annualized – still high in a historical context, but probably already too low to keep all the bubble balls in the air – click to enlarge.


So far, money supply growth rates were the one thing that has kept us a bit cautious with respect to trying to pick a market top or forecasting an economic downturn, in spite of the fact that a great many market data (especially valuations, sentiment and positioning data) and economic data have suggested for quite some time that the ice has been getting a lot thinner.

It is not possible to determine in advance what threshold in money supply growth rates needs to be undercut to bring the bubble to a halt. In light of the recently spreading weakness in market internals it seems to us though that we are probably quite close to this threshold. Dr. Skousen’s B2B index meanwhile confirms that the economy is already much weaker than it appears on a superficial level.



Risk continues to increase. Given how oversold the commodity-related sectors are they seem actually ripe for a rebound, but such a rebound would likely only establish even more divergences at the next short term peak. Meanwhile it appears that the economy may actually tip over into recession sooner than expected.

Note in this context also a recent article by Lee Adler on initial unemployment claims. While these statistics have looked exceptionally strong lately, this is actually a phenomenon historically associated with bubble peaks. Businesses are beginning to “hoard” workers as Adler puts it, usually at precisely the wrong moment.

The recent decline in narrow money supply growth is another “early warning” type signal, although we wouldn’t want to put too much weight on this just yet. Should the growth rate of TMS-2 begin to weaken as well from here on out, it would definitely be time to go on “red alert”.


Charts by: StockCharts, Dr. Mark Skousen, St. Louis Federal Reserve Research




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7 Responses to “The US Stock Market and a Major Recession Warning”

  • No6:

    My goodness, so it looks like the US economy hasn’t achieved escape velocity!

    • ab initio:

      Specially, considering all the keynesian government spending, taxpayer bailouts and Fed ZIRP and debt monetization. Trillions spent in goosing the market but done very little for the real economy. Considering the revolving door between Fed and Wall St, it all makes sense.

  • ab initio:

    Hussman has been noting the deteriorating market situation for over a year. He is in that not so odd situation where he completely missed the bull market in stocks and has been pounding that the market downturn is imminent for a long time. While he has some cogent arguments the implications in terms of timing are yet to be proven. This bull market is long in the tooth so at some point it will turn. I am not sure Hussman can claim any credit when it does occur although that will not stop him. One can be certain however that he will get back in early and to his chagrin may catch a falling knife.

    There is no doubt that the character of many markets are changing. The leaking in emerging markets – (currency, bonds and equities) as well as commodities implies that liquidity is waning. I am not sure what to infer from the carnage in precious metals mining stocks which have been clobbered down 80-90% from their 2011 highs. If the US stock market cracks we can be certain that QE will be back. The Fed at the end only cares about stocks while it pays lip service about the economy.

    • VB:

      Yeah, he’s been harping about overvaluation and deteriorating internals for something like five years already. While he is undoubtedly right that this won’t end well, his missives definitely should NOT be taken as market timing signals. Even a stopped clock is right twice a day and his clock seems to have stopped five years ago, if not earlier.

      • HonestlyExpressingYourself:

        Expecting to be handed market timing on a silver plate by Hussman is going too far. He holds himself to the highest analytical standards, including admitting he can’t call the top. He is simply observing what can be observed and admitting it doesn’t mean a top is imminent – but that risk is present nevertheless. Take from it what you will – his analysis is superb – and he puts it out for free every week. What a guy!

        • VB:

          My point is that his analysis is useless. Yeah, the market was overvalued five years ago. Yeah, it’s even more overvalued now. What if it simply keeps going up and becomes even more outrageously overvalued in another five years?! How would this “analysis” help you, except by keeping you from the upside the bull market?

          Also, I’ve seen many warnings and predictions in his analysis (yeah, I read it every week too) that turned out being simply WRONG – and when that became apparent, he didn’t say a peep in the spirit of “turns out we’ve been wrong on this one” (which good analysts like Pater or Clive Maund regularly admit when they are wrong). Remember when he was warning about the mortgage resets? Or how many times he has said that, by various metrics, the USA is already in recession or a recession is imminent?

          The only useful information that can be extracted from his analysis (and which is correct) can be summarized in one sentence: huge, credit-induced booms lead to over-valuations and are inevitably followed my similarly huge busts. But, if you are reading blogs devoted to Austrian economics, you already know that and don’t need Hussman to tell it to you.

  • SavvyGuy:

    Even though market internals have been weakening for quite a while now, as cogently summarized above, the market may be holding up due to scared capital fleeing Europe and looking to park Stateside.

    A big clue is the rising US Dollar, which would normally be market-negative as it impacts export earnings. However, the rising US Dollar also ends up making a flattish market look like a bull market when viewed from an international perspective, thereby drawing in more international capital and of course further strengthening the USD…a classic positive feedback loop.

    The exact same situation produced the bubble top in the Nikkei at the end of 1989 as the JPY was strengthening. I suspect something similar is happening in the US markets at this time. Nobody can foretell how long this positive feedback loop will continue, but there is a lot of “air” under the S&P 500 and a quick goodbye kiss down to the 1,550 level is long overdue.

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