A Wobbly Rally

I.C. Angles Investment Post…

At the end of October the stock market put in a double-bottom from the sell off that began in August, and has since managed to reclaim most of its lost ground. Although not yet able to challenge the market highs, the S&P 500 index is back to the sideways channel established over most of the year. But this is hardly reason to celebrate. The rally may have made up most of the lost ground from a terrible August, but this has been a very ugly rally that gives a lot of reason for concern about the future prospects of a stock market that is looking increasingly wobbly.

The stock market right now is looking like a fighter in a prize fight, who is still standing and swinging, but has taken some good punches to the head and a practiced  eye can see despite the fight that is still in him that his feet are getting wobbly, his punches losing power and his vision cloudy. He might survive the round. But absorbing another good shot or two is likely to put him flat on his back and out for the count. In the case of the stock market its underlying weakness can be detected in several unhealthy divergences.

First off, on a technical basis this market looks weak. Stock market breadth is anemic. Fewer and fewer mega cap stocks, like Google and Amazon, are making up more of the gains, while more and more stocks are fading. A healthy stock market experiences broad-based strength with most stocks doing well. That’s not the case with the current market, where many are fading and a dwindling few are carrying the load, based on in cases like Amazon, some extremely optimistic assumptions about sales and profit growth that are unlikely to transpire. John Hussman has an excellent chart published in late November illustrating the S&P 500 versus the number of stocks trading above their respective 200-day averages that shows the divergence between the performance of the cap-weighted stock market and most of the stocks that compose it.



Another method for analyzing the health of the stock market is to compare the Dow Jones Industrial Average with the Dow Jones Transportation Average. In a healthy economy and a robust stock market, the transports should keep pace with the broader Dow index. When they don’t it is often a sign of an underlying weakness in both the economy and stock market. The below chart shows just how wide the divergence has been this year. On a similar and related note, small cap stocks in the form of the Russell 2000 Index of small cap stocks also remains well below highs set this year and appear in serious risk of establishing a bearish downtrend.


Source: BigCharts.com


In fact, unhealthy divergences seem to be the rule with the current stock market rally. The high-yield or junk bond market is also signaling an ominous divergence. Oftentimes credit markets proceed a recession and serious stock market decline, as can be seen in the below chart.



All of these divergences are in the backdrop of weakening global economic growth, with many overseas stock markets already suffering serious declines. One of the repercussions of weakening global growth, has been an earnings recession in the U.S., as S&P 500 net profit margins decline at a rate indicative of recessions and bear markets.




In addition, one of the best illustrations of weakening global growth is witnessed in the divergence between the stock market and commodity markets, where prices continue to decline, as illustrated in the below chart comparing S&P 500 performance versus broad-based commodity performance. Strong global growth is typically correlated with higher demand and prices for commodities, while the converse is true for weakening growth. In addition, despite signs the Fed will be hiking rates, the U.S. economy itself is certainly not signaling strength with the manufacturing sector appearing to already be in recession.


Source: BigCharts.com


Maybe this stock market survives the current round, and perhaps it goes on to gain strength. At current levels, with the U.S. consumer and service sector still doing well, the bull case remains intact on a price basis provided the recently set lows in the S&P 500 are not retested and fail. But stocks are looking increasingly wobbly. Even if they put in a new high, the risk of this stock market getting knocked down are high and rising.



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