market internals

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The lesson to be learned was not that QE or zero interest rates are omnipotent in supporting stock prices. The lesson was not that valuations are irrelevant, or that “this time is different” in ways that investors cannot comprehend. The lesson was not that low interest rates make stocks “cheap” at any price. Rather, the lesson was that in the presence of zero interest rates, yield-seeking speculation can persist even in the face of obscene valuations and recklessly overextended conditions. So while one can become neutral, one has to defer a hard-negative market outlook until the uniformity of market internals explicitly deteriorates (signalling a shift toward increasing risk-aversion among investors).

Based on a century of market evidence, I concluded that the distinction is the psychological preference of investors toward speculation or toward risk aversion. Moreover, I found that the most reliable measure of those preferences was the uniformity or divergence of market action across a broad range of internals, including individual stocks, industry groups, sectors, and asset classes, including debt securities of varying creditworthiness. That distinction proved to be extraordinarily valuable. The combination of extreme valuations and deteriorating market internals is precisely what allowed us to anticipate the 2000-2002 and 2007-2009 market collapses.

A few more assertions about the financial markets may be useful to discuss. One with appeal to many investors is the idea that valuations may be high on an absolute basis, but that stocks are still “cheap relative to interest rates.” This too is wrong, but wrong in an interesting way.

As I’ve detailed previously (see The Most Broadly Overvalued Moment in Market History), investors often misinterpret the form, reliability, and magnitude of the relationship between valuations and interest rates, and become confused about when interest rate information is needed and when it is not. Specifically, given a set of expected future cash flows and the current price of the security, one does not need any information about interest rates at all to estimate the long-term return on that security. The price of the security and the cash flows are sufficient statistics to calculate that expected return. For example, if a security that promises to deliver a $100 cash flow in 10 years is priced at $82 today, we immediately know that the expected 10-year return is (100/82)^(1/10)-1 = 2%. Having estimated that 2% return, we can now compare it with competing returns on bonds, to judge whether we think it’s adequate, but no knowledge of interest rates is required to “adjust” the arithmetic.

One intuitive way to evaluate the impact of interest rates is to consider the effect of a given departure of interest rates from normal levels. For example, consider again a $100 cash flow that will be received 10 years from today. If the typical return on such an investment is 6%, the current price will be $55.84. But suppose we expect returns to be held down to just 4% for the first 5 years, then 6% after that. In that case, the current price will be $100/[(1.04)^5 x (1.06^5)] = $61.42. That’s 10% higher than our previous calculation. Why? Because in order to reduce the return from 6% to 4% for the initial 5 year period, the price has to increase by 2% x 5 years = 10%.

Accordingly, if you believe that market valuations should be tightly related to the level of interest rates (the correlation actually goes the wrong way outside of the 1970-1998 period, but let’s assume otherwise), it follows that if interest rates are expected to be 3% below average for the entire decade ahead, market valuations ought to be 30% higher than historical norms. The problem is that the most reliable valuation measures (those most tightly correlated with actual subsequent market returns in cycles across history) are currently between 130-160% above their respective historical norms.

An additional theory crossed my desk in recent weeks, which is that corporate profits are enjoying a “winner take all” phenomenon, which will allow large, dominant companies to retain monopoly-like profit margins indefinitely. Now, there’s no question that many internet-related companies have benefited from network effects that have substantially contributed to their size, as well as their market capitalizations. The question is whether this effect now dominates the profit margin behavior of U.S. corporations more generally. One anonymous analyst, who we like quite a bit for his (or her) analytical approach even when we wholly disagree, recently proposed that profit margins might be more broadly affected by this sort of systematic “winner take all” dynamic.

To that end, Patrick O’Shaughnessy compiled some data by separating companies into five bins based on their profit margins, and then charted the aggregate profit margins of each bin (chart below). The analyst proposed, “If our explanation is correct, then the aggregate profit margins of the higher bins should have increased more over the last few decades than the aggregated profit margins of the lower bins. Lo and behold, that’s exactly what the data shows.”

My response to this is straightforward. The conclusion is wrong, but it’s wrong in an interesting way. That’s not a criticism of either analyst, just an issue with the conclusion being drawn, and it provides an opportunity to learn something valuable. The problem here is that the analysis is an artifact of selection bias.

To illustrate, I generated 100 geometric random walks, and then sorted them into quintiles based on their ending values. It should be clear that the members of the top bin are, by definition, the ones that have benefited the most from randomness, and the members of the bottom bin are, by definition, the ones that have suffered the most from randomness. Even though the underlying paths are random going forward, grouping them by their ending values and then looking backward gives the impression that there is some systematic “winner-take-all” process at play.

That’s not to say that we can reject the possibility of a “winner-take-all” dynamic, but what’s actually required to demonstrate it is to sort the series at some point T, and then show that subsequent outcomes are systematically biased in favor of the early winners. Again, there’s no question that many internet companies benefit from this kind of dynamic (though their market capitalizations already vastly extrapolate the continued expansion of those network effects). For the market as a whole, however, I remain convinced that the main story behind profit margin expansion in recent years has been weak growth in real unit labor costs, and that this is likely to change in the years ahead, as the combined result of weak demographic growth in the labor force, substantially less slack in the U.S. labor market, and limited benefits from labor outsourcing on unit labor costs, given that lower wages often go hand-in-hand with lower productivity.

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Raymond James’s’s’s Andrew Adams is out with a reminder about the bear market you may have already forgotten about – it took place in 2015 in a very stealth way and effected all but the ten largest stocks in the S&P 500. The indices weren’t nearly as effected as their underlying components were, so it doesn’t show up in your favorite index ETF’s price chart, but, my friends, it was grueling.

Here’s Mr. Adams:

I’ve used this stat before, but it still astounds me that during 2015 if you had put all your capital into the largest ten companies in the U.S. stock market, you would have ended up making about 20% on the year, yet if you had held the other 490 companies in the S&P 500 instead, you would have actually been down about 3%. Talk about a strangely narrow market! Of course, that period culminated in the stealth tactical bear market in early 2016 when, at the February 11 low, the S&P 500 stocks were down an average of 26.7% from their 52-week highs and stocks in the Russell 3000 were down an astonishing 37.3%, on average. We still contend that was probably the “bear market” that many are still predicting even now, but it does not qualify in the eyes of some purists since the S&P 500 itself was “only” down about 15% from its previous all-time high instead of the requisite 20%.

Batnick and I were talking about this just now. We were screaming about this stealth bear as it was happening. Nobody cared much at the time in the financial media, because the index Bigs were holding up appearances.

But the enlightened investor takes note of this sort of thing and keeps it handy for the next time a doomer calls the present state of affairs “euphoric” or “irrationally exuberant”.

It wasn’t very long ago that the indices corrected through time, while their components corrected through price, beneath the surface.


Investment Strategy: “Charts of the Week”
Raymond James – April 19th 2017

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The whole problem with the world is that fools and fanatics are always so sure of themselves, and wiser people are full of doubts”

–Bertrand Russell

I always have admired the writings of British philosopher Bertrand Russell, who died in 1970, 14 years before the Russell 2000 Index was created and compiled.

The Russell Index, his “namesake,” now may be priced to perfection.

Nothing moves in a straight line, especially in the markets.

Fade the Trump small-cap rally, as hope seems to be triumphing over experience.

In “Donald Trump, You Are No Ronald Reagan (Part One)” and “Yell and Roar … and Sell Some More,” I struck a cautionary tone about economic and market cycles, political partisanship leading to delays or more modest tax reductions, and the leadership skills and avowed policies of President-elect Trump compared to those of President Reagan. I also compared the current market advance with the honeymoon the markets delivered 35 years ago. (I will be expanding on my thesis and concerns this week).

This morning, in “How Long Will We Ignore the Negatives of This New Presidency, ” Jim “El Capitan” Cramer voices and adds to many of my concerns.

While respecting the strength of the last month’s stunning and almost parabolic move (see Bertrand Russell’s quote above) and recognizing that the only certainty is the lack of certainty, the markets to this observer are overvalued on almost every basis and the reward versus risk is substantially tilted toward the downside.

My pal David Rosenberg, chief economist and strategist with Gluskin Sheff, shares my view that the market is being over optimistic:

“If you were to do a fair-value estimate of the multiple against where it is today, you could actually then back out what the implicit earnings forecast is. And right now, it’s 30%. That is the implicit earnings increase that is priced in. So if you’re buying the equity market today, just know that you’re buying an asset class writ large that is expecting a V-shaped +30% bounce in earnings growth over the course of the coming year. Trouble is, that it is a 1-in-20 event — and normally that 1 in 20 happens early in the cycle, not late in the cycle …. Actually, six quarters of negative comparisons. I mean, if the earnings recession is behind us and if there are Trump tax cuts ahead of us — even if I allow for the full brunt of corporate tax cuts — and if I allow for whatever nominal GDP growth is going to be, I still can’t get earnings growth much above 10%. 15% is a stretch, but you might still get there. But even that doesn’t get you to a 30% earnings expectation.”

–Welling on Wall Street: An Interview with David Rosenberg

So, what is the best short? Perhaps it’s the Russell Index.

“When all the forecasters and experts agree, something else is going to happen.”

–Bob Farrell’s Rule #9

In keeping with my negative market outlook for 2017, I am making Direxion Daily Small-Cap Bear 3x ETF (TZA) , at $18.78, my Trade of the Week. Here’s why:

* Over the last year the Russell Index has materially outperformed the broader indices: Since mid-December 2015, the Russell Index has doubled the performance of the S&P Index (up 24% compared to 12%). As Bertrand Russell noted, “extreme hopes are born from extreme misery” — at least if you have been short iShares Russell 2000 ETFIWM! (Note: In its history, the Russell Index never has been as extended relative to the Bollinger Bands.)

* The recent widening in relative performance (Russell vs. S&P) may be a function of the president-elect’s policies toward protectionism and against globalization; the timeliness and extent of impact might be overestimated.

* The Russell Index is more richly valued than the broader indices. The 2016 price/earnings multiple for the Russell Index is 32x and 25x 2017 estimates (before any new effective tax rate) on non-GAAP earnings. The S&P Index is trading at 19x 2016 non-GAAP and 17.5x 2017 estimates. However, the S&P multiple of GAAP is 26x — there is no currently available GAAP multiple of the Russell.

* As interest rates gap higher, the cost of capital is rising for small and medium-size companies: This is occurring at a speed far faster than many previously thought. Large, multinational companies have better and cheaper access to capital through the markets and/or on their cash-rich balance sheets. (Note: This morning’s move in the 10-year U.S. note yield to more than 2.50% may be a tipping point).

* The rate of growth in the cost of commodities and services is starting to accelerate. This hurts smaller domestic companies that are less diversified compared to the larger companies. Remember, mono-line smaller companies often have less pricing power than their larger brethren. (Note: This morning’s $2.35 rise in the price of crude oil to nearly $54 also may be a tipping point).

* Smaller capitalized, domestically based companies are not beneficiaries of possible repatriation of overseas capital. As Russell wrote, “Sin is geographical!”

* The president-elect’s infrastructure plans likely will be slow to advance. There will be some opposition from both parties, members of which will be looking for a revenue-neutral and not “budget-busting” fiscal jump-start. At best, this is a 2018-2019 event. Moreover, the build-out could benefit some of our larger companies (e.g., Caterpillar(CAT) and United Rentals (URI) ) over smaller companies. In the broadest sense, however, infrastructure build-outs rarely contribute to sustained prosperity; just look at the sophisticated and state-of-the-art infrastructure in Japan.
That build-out has failed to bring sustainable economic growth to that country. The same can be said for Canada, which is mired in a 1% Real GDP growth backdrop despite Prime Minister Trudeau’s large infrastructure spending of years ago.

* The president-elect’s immigration policy — building a wall, limiting in-migration and exporting those who are in our country illegally — are not pro-domestic growth and could hurt small to medium-size companies.

* The president-elect’s China policy and broader protectionism policy could end up hurting the sourcing (impacting availability and cost) of many smaller companies, potentially squeezing profits by lowering margins and reducing sales.

Bottom Line

“All movements go too far.”

–Bertrand Russell

My view is that the Russell may soon stop crowing and I am moving toward a more aggressive short of that Index.


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Market internals have been used as evidence for the strength in the market. Market internals however need to be used carefully.

When looking at market internals, both volume and price continue to lag the NYSE Advance/Decline (A/D) line, a metric that continues to hit new highs, but as I explained in a prior column, the A/D line you see thrown around in the media isn’t as significant as it looks on the surface.

At the risk of going on a tangent, head back the article on how the NYSE Advance/Decline line lies to you for a more in-depth explanation. Bottom line here is that in healthy bull markets, all three of the A/D line, price movement, and volume tend to move northward together, and that’s not what’s happening today.

Margin debt is also back towards the highs, another danger sign.

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Earnings remain an issue.


Will the S&P 500 be higher or lower than its current level one month from now?
Higher 46% 143
Lower 54% 167

310 votes total




The S&P 500 broke out to a new all-time high today but didn’t manage to finish the day above its 1/15 all-time closing high. Nevertheless, the index is pretty much right back where it was on January 15th after experiencing a fall of nearly 6% and a subsequent rally of 6% in between.

Below is a look at sector performance during the market’s recent “round trip” since the close on 1/15. As shown, the overall market is flat with the S&P 500 down just 4 basis points, but there have been clear winners and losers underneath the surface. Interestingly, the two smallest sectors of the market — Telecom and Utilities — are on opposite ends of the chart, with Utilities up the most at 6.44% and Telecom down the most at -3.36%. Keep in mind, though, that the moves in these two sectors have very little impact on the S&P given their extremely low weightings in the index.

Of the sectors that do have an impact on the index as a whole, Health Care, Energy and Technology are higher now than they were on 1/15 when the market made its last closing high. Financials, Consumer Staples, Industrials and Consumer Discretionary, on the other hand, are all lower, and their underperformance is what has held the market back. These sectors have all bounced off of their early February lows, but they still haven’t gained back all of their losses from the 1/15 to 2/3 pullback. Now that we’re right back to prior highs, will the leaders (Health Care, Energy, Technology) continue to lead, or will investors move money out of recent winners and into the laggards?

As shown in the second chart below, breadth levels are elevated for the areas of the market that have outperformed, and they’re just above the 50/50 mark for the lagging sectors. If you’re looking to put money to work but don’t want to chase overbought names, there are plenty of stocks still trading just above their 50-days in cyclical sectors like Industrials, Financials and Consumer Discretionary.

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