High Yield Credit Divergence

September 29, 2014

The S&P500 fell almost 1.4% last week on moderate volume. This loss reversed most of the gain booked the week before. Examining volume in more detail, we saw that it spiked the most on the day that the equity markets fell the most; and volume fell on days when prices rose. To repeat, this is not a sign of a strong bull market. Volatility jumped almost 23% as measured by the VIX index; but this is to be expected when prices slip.

In terms of technical analysis, prices broke below the 50 day moving average on the S&P. While they later recovered a bit to close above, this is a violation of an uptrend, and this break will raise concerns among all technical traders. On the daily charts, prices have retreated just a bit from their upper Bollinger band; the same has happened on the weekly charts. So while  the S&P is not quite as overbought as they were two weeks ago, they are still only a couple of percentage points away from their all-time highs. Meanwhile, breadth continues to deteriorate—for example, at no time during 2014 were fewer stocks above their respective 150 day moving averages than at the close of trading on Friday. Not good.

At the same time, the US economy is still inching forward very, very slowly, and this is despite the $3.5 trillion created by the Federal Reserve since 2008 to save the financial system and the US economy. Certainly, the US financial system has been “saved”; the US economy, not so much.

In specific news, the Chicago Fed national activity index plunged, instead of growing as expected by economists. Existing home sales dropped, also, instead of rising as expected. The house price index disappointed. The PMI manufacturing index also disappointed. Durable goods orders missed—both headline and without transportation. Also, the Kansas City fed manufacturing index missed expectations. On the positive side, only new home sales and initial jobless claims beat consensus estimates.

Last week, we noted that while the S&P500 was creeping up to new all-time highs, that the Russell 2000 was not only dropping but showing a small loss for the year. This. we concluded, was a serious bearish divergence that should put all equity investors on alert.

This week, another serious bearish divergence must be noted. While the S&P500 continues to hover only a couple of percentage points away from all-time highs, the high yield credit market has recorded some serious losses over the last several weeks. And not only have high yield prices (eg. on the ETF HYG) broken below the 50 day moving average, but the 50 day moving average is sloping downward and about to slice below the 200 day moving average—this is better known as the Death Cross, a very important technical indicator that often marks the start of a bear market.

Why does high yield matter to the stock markets? Because both markets trade in risky assets, they are usually highly correlated. And since high yield is breaking bad, this becomes a strong force on equities to follow along. Once again, we’ll know in a few short weeks if stocks do in fact follow high yield down in price, or if somehow, high yield reverses course and rockets up to join its stock market cousin.

Small Cap Divergence

September 22, 2014

Well once again, the S&P500 bounced back last week, reversing the prior week’s losses and setting a new high. The S&P rose 1.25% and touched another new record high, before retreating somewhat on Friday, which was the only day of the week when volume jumped. Volatility, as expected in a week when prices rose, dipped back down to the bottom of a multi-year range that can best be described as a zone of complacency. Investors are clearly not worried about any meaningful downside risk to equity prices in the S&P500.

Technically, the charts are once again highly stretched—they suggest that the S&P is very over-bought. But given that this has been a recurring phenomenon over the last two years, once again, this condition is no longer raising any serious concerns among even some of the most seasoned long-term professional investors. To back this claim up, the percent of investment advisors who call themselves “bearish” on US equity markets remains stuck near multi-decade lows.

In terms of economic news, the big story of the week was inflation…or rather the lack of inflation. Consumer prices—both headline and core—were reported at levels far below expectations. In fact, headline inflation was negative. This suggests that wage inflation is still not even close to being a problem (and with the labor force participation rate near multi-decade lows, this is no surprise) and that now even the goods market (as opposed to the labor market) is slowing down in terms of price pressure. Adding to the slow-growth thesis was the industrial production result—instead of rising 0.3% as expected, it dropped 0.1%. Housing starts also missed…..badly, as did leading indicators. On the positive side, initial jobless claims fell below 300,000 and the Empire State Manufacturing Index beat expectations.

Finally, an interesting development is occurring in the small cap stock indices (eg. Russell 2000)—in direct contrast to what’s happening in the large cap indices (eg. S&P500).

While the S&P trudges on to greater and greater heights, the Russell 2000 finished last week in the RED for the year! On top of that, the Russell is about to complete a very bearish formation called the Death Cross—where the 50 day moving average crosses below the 200 day moving average. For most market technicians  (based upon decades and decades of history) this is one of the key signals that a bear market is starting in an index.

In terms of what this means for the S&P500, this is a major bearish divergence. This means that while some key leadership stocks keep propping up the major market index (the S&P) most stocks in the US—or the thousands of small caps—are dropping and entering bear market levels, when they’ve fallen by 20% or more from their most recent highs.

This divergence is resolved in only two ways—either the small caps reverse course and leap back up to match the lofty heights of the S&P500…..or……the S&P500 converges with the Russell 2000 by dropping down to match it.

Historically, the most common way this divergence was resolved was with the Russell leading and the S&P following. Did it ALWAYS happen this way? No…..but in the vast majority of times, it did. Let’s see what happens this time.

Bearish Sentiment

September 15, 2014

Last week, the S&P500 lost 1.1%, registering its first notable weekly decline since early August. Sure enough, volume rose, in direct contrast to more frequent weeks when stocks rise on declining volume. Clearly, the implication is that there’s a lot of pent-up selling pressure and that volume could explode when or if stocks ever sold off meaningfully. Also unsurprisingly, volatility jumped somewhat, as one would expect in a week in which prices dropped.

Technically, last week’s decline did very little to alleviate the extremely overbought condition of the S&P, on both the daily and the weekly charts. Stock prices continue to drift higher into record-setting territory, without so much as a mild 10% correction since mid-2012. At the same time however, breadth is not as strong as it was during earlier record-setting moves. For example, the percent of stocks above their 150 day moving average is far lower than it was in much of 2013, when stocks were setting record highs,,,,but at prices far below where they are today. Once again, this means that index prices are climbing not because most individual stocks are rising, but because several key leadership stocks are risking and pushing the overall index higher. In fact, in the NASDAQ, a big percentage of stocks are in bear markets, despite the strong overall index price level.

US macro news last week was, on balance, disappointing. While consumer credit growth and consumer sentiment beat expectations, most everything else missed. Job openings (from the JOLTS) survey were lower than expected. Wholesale trade badly missed, and so did initial jobless claims. Retail sales only met consensus forecasts.

Finally, an interesting development is building up in the world of investor sentiment, especially among investment advisors. Investors Intelligence has been monitoring, on a weekly basis, investors sentiment (the percent who are bears and the percent who are bulls) for several decades. And while we’ve noted in the past that the percent who are bears had dipped below 20% during various times in 2013, the latest development is even more stunning—the percent who are bears has now dropped below 15%……..specifically to 14%.

On the surface, this development looks positive. Almost everyone now is bullish. And if everyone is bullish, then a lot of smart people seem to agree that things–broadly speaking–look good for stocks going forward. So, if any single investor is bullish, then he or she would be joining the vast majority of others who think the same thing.

On the other hand, the percent of bears at 14% has now fallen to lows not seen in over 20 years. And this begs the question—if everyone is already bullish (and presumably a buyer of stocks), then who’s left to enter into the market to buy stocks and propel prices even higher?

And an even more worrisome question is this—since most everyone is already bullish, if some negative shock were to hit the markets, who’s going to be doing the buying if most everyone who was bullish decides to become a seller?

The more one thinks about this question, the more one is left with the dreadful conclusion that if a panic were to hit stock markets, then there would be almost nobody available to buy—-at the old record-high prices.

Would buyers emerge eventually? Sure, but they always emerge only after prices have fallen….substantially.


Why Stock Investors will get Trapped in the Next Correction

September 8, 2014

The S&P 500 edge up a fraction of one percent last week on extremely low volume, which was in part due to the Labor Day holiday. Volatility crept up very slightly, as it continue to hover near historically very low levels.

So the S&P has once again bounced back from a minor sell-off to regain not only all the prior losses, but to set another new high, slightly above the previous high. In terms of technicals, the equity market has once again returned to an extremely overbought state, both on the daily and weekly resolutions. Interestingly, however, another risk asset market—high yield debt—never regained its former highs. What’s worse, over the last two weeks, HYG has resumed the downturn that first began in July. Will credit lead equities again this time?

In the world of macro news, last week’s announcements were very mixed. On the positive side, both ISM manufacturing and ISM services handily beat expectations. Our trade deficit was also not as bad as feared. And construction spending came in better than estimated. On the negative side, factory orders—when removing the volatile aircraft orders—fell by almost 1%. Jobless claims were worse than expected. The big number of the week, August payrolls, was disaster. Instead of the 230,000 new jobs expected, only 142,000 jobs were created. And to add insult to injury, the labor force participation rate slipped back down to multi-decade lows.

How did equity markets react to this dismal jobs report?  They jumped higher on the perverse belief that bad news is good news because it will force the Fed to boost monetary stimulus which most everyone feels will just roll right back into stocks and push prices higher.

One person who is growing increasingly worried about the current run-up in stock prices is money manager John Hussman. In a recent note to investors, he attacks the notion that so many traders and investors in the US believe to be true—the notion that they will keep their money invested in stocks (Hey where else can you put it? Certainly not near zero yielding Treasuries, right?) until the markets turn down, and at that point, they’ll be among the first to “get out” and sell.

Hussman notes:

Why won’t most investors get out? The answer is that in equilibrium, they can’t. On any given trading day, only a fraction of 1% of total market capitalization changes hands, and the vast majority of that is high-frequency trading and portfolio reallocation between existing equity holders. Think about it – the only way for an investor to get out of stocks without someone else getting in is for the stock to be literally removed from the market. That source of net removal of stock is corporate repurchase activity, which recently hit a year-over-year pace of about $500 billion. That’s still less than 4% of total market cap in an entire year, and it’s a fairly good upper limit on the percentage of investors who will successfully get out of this bubble without the appearance of a miraculous multitude of greater fools at the very moment existing holders decide to sell.

So there you have it—simple numbers. Most owners, if they all chose to sell at once (which is exactly what happens in a panic) will not have any buyers of their stocks, at least at anywhere near the prices that they expected. Will there be any buyers at any price? Sure, but history shows that when prices have entered into bubble territory, and Hussman is forcefully arguing that this is the case today, then these buyers typically start to emerge only after prices have fallen by 30% and often by 50%.

In short, most investors are sitting on paper gains, and that when the selling starts—-and it has ALWAYS started in the past—that most investors will never be able to successfully retain these paper gains. They will get trapped.