Technically Troubling

I.C. Angles Investment Post…

Despite worrisome characteristics around this bull market, it was not until October of this year that I recommended long-term investors move to underweight stocks. I had remained reluctantly bullish previously, because from a technical perspective of looking at price and volume behavior, including the 125-day simple moving average, the market was simply too robust to bet against in my opinion. But that has changed, and there are several technical indicators, beyond simple moving indicators, that are now cause for concern. It is said no one rings a bell at a market top. That is true. Nevertheless there do tend to be warnings, often recognized in hindsight. And there are some technical warning bells now ringing that previously were silent. Whether they are prophetic or a false alarm, will only be known with the benefit of time. However, given other risk factors, including the overpriced nature of this market, my advice remains to underweight stocks.

Dangerous Divergences

Even as the S&P 500 makes new highs, other markets have diverged, signaling trouble ahead. Crude oil has recently been in the headlines for its precipitous drop. But oil is not the only commodity market signaling weakening economic growth. Copper, nickel, iron ore, as well as agricultural commodities, are also signaling trouble ahead. Price action in the bond market is also bearish. Treasuries are signaling a stock market downturn. In October, high-yield bonds joined Treasuries, in signaling trouble ahead for U.S. stocks. Along with commodity and bond markets, many foreign stock markets are also exhibiting worrisome price action.

Perhaps the commodity and bond markets are sending false signals, and foreign stock markets are decoupling from the U.S. stock market. But if the U.S. economy is going to be so much stronger, why has the Russell 2000 U.S. small cap index struggled with largely sideways price action for the year, while the S&P 500 large cap U.S. stock index, with more foreign exposure, surged? Perhaps it’s because retail investors are loading up on S&P 500 index products, as they chase past performance, and traders are using such products to play a trend that looks increasingly shaky. In addition, a pillar of price action strength for this bull market, has been those large cap stocks, borrowing money and using their profits to buyback their own stock, thereby artificially pumping up their earnings per share. In my view diverging price action strength, based around impairing balance sheets to buyback richly priced stock is not a positive.

And it is internal divergences within the stock market, as well as those without that are an increasing cause for concern. For instance, low beta defensive stocks are showing rising strength, rather than the high beta stocks that should lead a strong bull market. The advance decline ratio is also deteriorating, with fewer stocks making new 52-week highs, while others show weakness, including stocks that should lead a healthy rally. Correlations are breaking down between U.S. stocks and sectors, as the internal price action of the stock market becomes more negative, and negative divergences are appearing in terms of the Moving Average Convergence Divergence (MACD) momentum indicator. In addition, recent market volatility is reminiscent of price action at the 2007 and 1987 market tops. Of course, none of these technical indicators mean a big stock market decline is imminent. There is plenty of room for debate around their implications, but it is clear in my opinion that the technical picture is considerably less bright than previously.

Not even the so-called Hindenburg Omen that has recently been sighted, which sometimes signals a bear market, based on a mix of technical factors, is a foolproof indicator. Although John Hussman of Hussman Funds makes a strong case for paying it heed, “Recent market action includes a concurrent expansion in the number of individual stocks setting both new 52-week highs and new 52-week lows. This is also an indication of growing internal dispersion. As I’ve noted before, instances where both new highs and new lows exceed, say, 2.5% of issues traded are relatively common, and represent practically useless information. Observers incorrectly identify these as “Hindenburg” signals, which get a bad rap as a result. A better definition of a Hindenburg requires additional signs of dispersion – strength in the indices coupled with weakness in the internals, and multiple signals within a few weeks of each other in order to filter out one-off outliers. Those signals, though more useful, are also somewhat spotty. However, when they occur in the context of rich valuations and negative trend uniformity on broader measures, we sit up and take note. Aside from one instance in August 2013 that was followed by just a quick 5% pullback, the only points in recent years we’ve seen that combination turned out, in hindsight, to be the 2000 and 2007 peaks.”

Although I have previously not been as bearish as Hussman, at this point, due partly to technical indicators, I have now moved into his camp in viewing stocks, as having a very poor risk/reward profile for all investors. In terms of the U.S. stock market, I find myself looking to 2015 with far more trepidation, than the predominantly bullish consensus. To call a bear market, I need to see more negative technical evidence, including obviously for the S&P 500 to stop making higher highs. But with the worrying signs around this latest rally, including notable divergences, as well as once again record margin debt amounts that appear to be possibly cresting in a manner similar to the 2000 and 2007 tops, I have seen enough to recommend investors underweight stocks.





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