market internals


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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.

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

310 votes total

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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.

sector change 115

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Chart is still doing the rounds. It has been dismissed by many. But it still remains on the peripheral of trader consciousness. The question is: a bull market built on QE, can that market survive without QE? The 2000 bear market was preceded [by about a year] by deteriorating market internals, but that was a regular sort of bear.

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These are NYSE 52 week High vs Low Ratio averaged over one month, NYSE Advance Decline Line averaged over three months and S&P Percentage of Stocks Above 200 MA.

Interesting observation we can make about the chart above is that during the recent correction, is that over one third of S&P stocks dropped below their 200 MA. This was the first time breadth readings dropped below 75% since late 2012. The question is, was this sell off an indication of something bigger to come or was it just another correction in the uptrend?

While it is difficult to answer that question, the overall breadth indicator complex continues to resemble weakening and declining uptrend participation. In other words, there are bearish divergences between index price and underlaying breadth since May 2013, as taper talk pushed interest rates higher.

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