An Impressive Rebound, but Hollow Inside

In his recent weekly market update, John Hussman once again discusses his main bearish argument, namely the combination of market overvaluation and deteriorating internals. He rightly (in our opinion) regards the latter as a signal indicating a shift in risk appetites. Here are two quotes from the article summarizing the essential points:

 

“Valuations are the primary driver of long-term returns, and the risk-preferences of investors — as conveyed by the uniformity or divergence of market action across a broad range of individual stocks, industries, sectors and security types (including credit) — drive returns over shorter portions of the market cycle.”

[…]

“The combination of extreme valuations on historically reliable measures, the deterioration of market internals following an extended period of overvalued, overbought, overbullish conditions, and the weakening of leading economic measures, particularly on measures of new orders and order backlogs, has clear precedents historically, and those precedents are uniformly bad.”

 

leakImage via aufinia.com

 

We would add to this that while it is true that the precedents with similar combinations of factors are uniformly bad, there are always different lead times involved before cap-weighted indexes actually peak. These moves toward the eventual top can have blow-off-like characteristics, such as in 1929 (when stocks like RCA and other “story stocks” of the time rose to a frantic peak while the larger list of stocks was already weakening), 1973 (the “nifty fifty” era) or more recently, the year 2000 blow-off in technology stocks. The latter event was highly unusual in terms of size and speed, but it shows what can happen.

However, even if we assume that in today’s case the lead time will be larger than usual (and a blow-off will happen and thus be of a size that will be greater than average), it would only tell us – again based on historical precedent – that the subsequent losses will be all the more devastating (e.g., what happened subsequently to the year 2000 blow-off was a more than 80% decline in the Nasdaq; the 1929 blow-off in the DJIA was followed by a 90% wipe-out). Unless that is, if central banks decide to go “Zimbabwe” on us (we don’t assume that they will, but if they did, one could probably sell a big position in, say, NFLX for $10,000/share one day, and to paraphrase Kyle Bass “buy three eggs with the proceeds”).

Currently, the cap-weighted indexes as well as the Dow Jones Industrial Average are in fact already supported by blow-off like rallies in several of the stocks that have the biggest influence on the indexes either due to their capitalization weighting or their price weighting (GOOG, AMZN, MCD, etc.).

Below is a chart illustrating the situation in terms of the very broad NYSE Index (NYA), which conveys a much better picture of how the average diversified portfolio is doing (it has made no progress in quite some time) than the more popular indexes or averages. Included is the percentage of NYSE listed stocks above their 200 and 50 day moving averages. The latter measure has almost re-entered “short term overbought” territory, but only 35.9% of all stocks included in the NYA are actually above their 200 dma. It seems to be a bull market in which most stocks are actually in a bear market.

 

1-NYA and internalsThe NYA with the percentage of stocks above the 200 dma (black line) and above the 50 dma (red line) – click to enlarge.

 

Along similar lines, we can see that there are now two recent divergences between the NYA and its cumulative a/d line. In the recent rebound, its a/d line has performed better than price, because a number of very oversold sectors have joined the short term updraft (with many remaining well below previous highs).

 

2-NYAD divergenceThe NYA cumulative advance-decline line vs. the index – click to enlarge.

 

Still, this recent improvement in the a/d line could be a potential “blow-off” precursor. It could also presage an improvement in internals, but this obviously hasn’t happened yet. As long as it hasn’t, the message remains negative. There are a few more developments that suggest that the recent rebound is lacking in broad support. One is the continuing divergence between Dow Industrials and Dow Transports. The two averages have confirmed each other only on one occasion in the past year: at the low in August. Dow Theory aficionados can’t be too happy about that.

 

3-INDU vs. TRANDow Industrials Average vs. Dow Transportation Average. The red circles indicate the sole decisive confirmation amid a plethora of non-confirmations (indicated by the blue lines) – click to enlarge.

 

The other problem is the continuing drifting apart of big cap vs. small cap strength. The next chart shows the ratio between the Russell 2000 (RUT) and the S&P 500 index (SPX), which illustrates this quite clearly. Below the ratio we show the SPX, which has been one of the best performing indexes in the rebound.

The reason why this divergence is even more concerning is the fact that the Russell has been a leading index between 2009 – 2014, gaining in relative strength through most of this period (with a brief interruption in 2012, before the start of QE3). This relative outperformance peaked and ended essentially when QE3 did. This means that since then, there is no longer enough monetary inflation to keep all the bubble-plates in the air, so to speak.

 

4-RUT-SPXThe RUT-SPX ratio is once again weakening, a trend that has been in place – not coincidentally, we think – since approx. the end of QE3 – click to enlarge.

 

Lastly, here is a chart showing a few stocks the cognoscenti running assorted funds have recently piled into with gay abandon on what were overall at best mediocre news. This narrowing of trends, with money increasingly flowing into assorted story stocks that are already trading at nosebleed valuations is a typical very late cycle phenomenon – especially when numerous stocks considered more cyclical (i.e., “economically sensitive”) are mired in severe downtrends (as an aside, we’re not necessarily implying all the stories are “bad”).

This indicates that a “we have to own something” (especially as year-end approaches) psychology is at work, with the choices made mainly on momentum considerations. As per above, it cannot be known in advance how long this urge to pile into a handful of big cap names will persist. As can be seen, several similar post-earnings gap-up gains have been maintained and extended so far – however, the backdrop in terms of market internals has steadily worsened during this time.

 

5-Blow-off stocksFour recent examples of short term blow-off moves in big cap stocks during the Q3 earnings season – GOOGL, AMZN, MCD and MSFT.

 

The Believers are Back

For a while, the rally off the August warning shot low was also supported by the build-up of skepticism following the sell-off. However, this particular type of rally fuel is beginning to run low as well. We have picked two charts illustrating this: the CBOE equity only put-call volume ratio and Rydex money market fund assets. Both are primarily indicators of small trader sentiment, but they are also a useful microcosm of wider sentiment.

 

6-CPCEThe CBOE equity only put/call volume ratio. It still has some room to decline further, but it is already low enough to indicate that the recent rally has managed to largely wipe out any lingering doubts about the market – click to enlarge.

 

7-Rydex money market fund assetsRydex money fund assets – the same applies to this series. It could still go lower, but is already low enough to confirm that the rebound has convinced the crowd – click to enlarge.

 

Bonus Chart: Announcement Draghi

It is interesting that since the ECB has started with sovereign bond QE in March of 2015, European stocks are actually down. Most of their remaining gains to date that could be called “QE-related” were purely a result of the announcement effect, but not of the actual deed. Even a sliver of the announcement effect has been given back at the time of writing.

The market has evidently discounted quite a bit of the inflationary effects in advance, but this also shows that the old adage that the central bank has no control over where the money it prints will actually go remains true. The asset class that has benefited the most in terms of truly egregious price distortions in Europe are government bonds on the short end of the yield curve. By way of illustration, here is the Euro-Stoxx 600 Index, a kind of European version of the SPX:

 

8-Euro-Stoxx 600ECB QE and European big cap stocks: all the gains remaining to date were related to the “announcement effect” – click to enlarge.

 

Conclusion

If one looks at the NDX alone, one would have to conclude that the bull market is perfectly intact. The same is true of selected sub-sectors, but more and more sectors or stocks within sectors are waving good-bye to the rally. Even NDX and Nasdaq Composite have begun to diverge of late, underscoring the extreme concentration in big cap names:

 

9-NDX vs. COMPNDX vs. Nasdaq Composite Index – that the rally is increasingly carried by a handful of big caps is evident here as well – click to enlarge.

 

Naturally, divergences can be “repaired”, and internals can always improve. As John Hussman inter alia mentions, if that were to happen, he would become more constructive about the short term outlook even though the market would remain egregiously overvalued.

The reality is however that we have been able to observe weakening internals and negative divergences for a very long time by now, and they sure haven’t improved so far. In terms of probabilities, history suggests that it is more likely that the big caps will eventually succumb as well. However, there are a handful of historical instances when this phase was preceded by an increasingly narrow blow-off rally.

The reason why this possibility has to be considered is that the current situation remains rather unique in terms of the monetary backdrop (two of the biggest central banks are printing money outright (ECB and BoJ), one is frantically cutting rates (the PBoC), and only one (the Fed) is threatening to raise rates from zilch to almost zilch, a threat that has lost a great deal of credibility over the past year (besides, US money supply growth in terms of TMS-2 remains at a brisk 8.35% y/y). However, the uniqueness of the situation means also that we cannot rule out a different outcome, especially in light of the persistence of negative market internals.

As we noted to a friend:

 

“What does one have to do to make money in such a market? If one assumes a continuing blow-off, one has to buy into precisely the portion of the market that is the by far most overvalued (most of the stocks normally considered “value stocks” are in downtrends) and then hope for the best (or rather, hope that one will be able to time one’s exit before everybody else decides to get cold feet for whatever reason).  If one wants to benefit from the downtrend in “value” by shorting these stocks, one is subject to precisely the same risk (e.g. after 2000, the bear market was characterized by a big rotation out of the big caps that had done so well into everything that hadn’t).”

 

Luckily that is not a problem for individual investors and traders, who are not bound by any constraints due to fund mandates/restrictions, liquidity considerations, fiduciary duties or career-related worries. Cash is not always trash.

 

Charts by: StockCharts, BigCharts

 

 

 

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