Unemployment at 3.8%, earnings growth at 26%, Q2 GDP growth pegged at a solid 4% or so, $NDX and small caps making new all time highs week after week. Markets ignoring all potential bad news (i.e. potential trade wars, political drama, etc) and volatility again crushed with no signs of fear or concern with a record corporate buyback program to the tune of $650B offering a consistent bid under the market. In short: Everything looks rosy.
So why is the broader market not taking notice? Why, in fact, is the broader market not only not making new highs, but why is the vast majority of the stock universe not only lagging, but showing potentially larger bearish patterns?
These are important questions for investors to consider as a number of market mysteries are unfolding beneath the positive headlines.
Consider the massive bifurcation we are witnessing:
Here’s the $NDX screaming to new highs, yet the broader $NYSE is not only down on the year, but it negatively diverged during the latest $NDX rally:
Let’s dissect them both a bit.
Firstly, the $NYSE, not only is not anywhere near the January highs, but it’s engaged in a potential larger bear flag pattern:
Never mind the January highs, the index is well below even its February and March highs, despite the recent rally that has followed a now regularly scheduled program of rallying near the beginning of each month:
Indeed, here we are after a multi-week rally and nearly 42% of $NYSE components remain below their 200 day moving average:
And don’t think $NYSE is the only index exhibiting this notable relative weakness.
Consider financials who have shown record earnings and theoretically should be benefitting from tax cuts and buybacks are also struggling. Consider that financials are in essence flat on the year and Goldman Sachs is actually down 8% year to date.
Indeed the financial sector, like $NYSE, is exhibiting a bearish chart pattern:
Contrast this with $NDX which just last week again printed new all time human history highs. $FAANG stocks such as $AMZN, $NFLX, etc are marching on to new highs every day. $NFLX is up over 100% on the year, $AMZN up 46%. Stocks that keep expanding market caps to unseen levels and appear bulletproof.
Yet here too, in the almightily $NDX, we can observe a massive bifurcation. Note with each rally the number of $NDX components reaching above their 200 day moving average is getting weaker and weaker, an internal deterioration that has led to market accidents in the past:
The main message: Index gains are driven by fewer and fewer stocks.
Again I have to ask: If things are so great then why are thousands of stocks not participating in this rally?
As I’ve outlined previously the narrowing of value expansion in favor of the few has became ever more pronounced in this latest rally. The data exemplifies the divergences and because of the market cap concentration indices are masking the underlying weakness in the broader market.
Part of this is of course driven by the reality of ETF allocations which automatically allocate funds and these benefit the top components who disproportionately drown out everything else.
Most notable of course in $QQQ where the top 10 components (out of a 103) control 55.7% of the asset value:
And these stocks, in addition to buyback benefits, continue to receive automatic ETF allocations due to the indexing effect. During the past couple of years in particular we’ve seen a massive shift in investor behavior away from active investing to passive (speak ETF allocations) investing.
The result: Investors who think they are diversified when buying an index fund may be a lot less diversified than they think they are.
The implication: Complacency is back in full swing again as volatility has been sucked out markets with $VIX again showing readings in the 11/12 range. $VIX at 11/12 with large swaths of stocks below their 200MA?
Last week we actually witnessed a bit of a flash crash in the underlying volatility index on the $RUT, the $RVX:
Ever since the lows of the financial crisis markets have been in a well defined pattern of volatility compression. During the February correction this pattern has been challenged, but it held in the $RUT. Yet last week it crashed to a new all time lows just as $RUT is approaching 2 long term resistance lines. Indeed, this volatility flash crash suggests the potential for a long term bottoming candle which could signal the end of the low volatility game coming to markets.
Consider the larger $VIX. In February it broke above its multi year descending trend line. The recent rally has seen it defend this trend line several times over suggesting a bullish pattern in the $VIX:
The bottom line here: Select key sectors are making new highs on ever weakening internal participation, while other sectors are showing distinct underperformance and bearish patterns as volatility patterns suggest potentially bullish patterns.
How to square these conflicting signals with all the good news seen in the headlines. Here’s a hint:
Just remember, great economic data tends to cluster around market tops, while horrid economic data tends to cluster around market bottoms (put another way, markets bottom on hope and top on hype) #perspective pic.twitter.com/96OhprSYIN— Liz Ann Sonders (@LizAnnSonders) June 14, 2018
Which brings me to the initial question: Why are we seeing all these bifurcations?
Here are some observations that may yield some clues as to the answer:
The outsized earnings growth we are witnessing in 2018 is not sustainable. Achieved mainly via fiscal stimulus earnings growth is peaking in 2018 and will be much more subdued in 2019 to the tune of 5% if things go well and larger margin compression can be avoided. This is also true for GDP growth as there is precious little evidence for expanding GDP growth into 2019 and 2020.
Here’s the Fed’s consensus real GDP growth forecast:
Does not appear to be expansionary to me.
The message: Earnings growth and GDP growth are both peaking in 2018.
At the same time yields are rising and we see it on the short end:
Competition is emerging in the supply/demand equation as yields are rising above the S&P 500 dividend yield.
Central banks are pulling back in stimulus. The Fed will, albeit slowly, keep raising rates and reducing its balance sheet and the ECB will end QE by the end of 2018. In short: In 2019 there will be a lot less artificial stimulus to go around as the cost of financing is increasing and earnings growth will be slowing down.
And fiscal stimulus, while headline friendly, comes at a real cost and we can already see its impact in the early budget figures:
To summarize:— Sven Henrich (@NorthmanTrader) June 12, 2018
YoY cumulative US budget May 2017 vs 2018:
Deficits increased from $433B to $532B
Corporate tax revenue declined from $166B to $124B
Interest on debt went from $198B to $233B
Spending increased from $2.6T to $2.72T pic.twitter.com/SXvPKJBbHH
As bullish as 3.8% unemployment appears on the surface historically speaking there is no evidence to suggest that such low unemployment is sustainable for an extended period of time. Indeed, quite the opposite is true as the only points of precedence suggest reversions into the 6% range accompanied by a recession:
So perhaps all these bifurcations we are witnessing in markets are not mysteries after all. Rather we are seeing markets negotiating the positive impacts of an artificially induced sugar high with money allocated into ever fewer participants on the one hand, and weakening participation on the other hand, perhaps beginning to price in a new reality: 2018 is shaping up to be a peak growth year at the end of an extended cycle that was brought about by central bank intervention, artificial low rates and global record debt expansion, all of which will be headwinds in a rising rate and deficit expanding environment with less stimulus to be had.
All of which can be summarized in a single macro chart:
No larger trends have broken at the time of this writing, but a renewed corrective phase accompanied by higher yields would put these long term trends to a significant test.
While markets have ignored US politics so far they may not much longer as mid term seasonality is upon us. Since the 1960s mid term election seasonality has seen market drawdowns between 7% to 37% sometime between the June to October timeframe.
Good thing the $NDX is not technically extended much:
All kidding aside, the larger evidence suggests that the recent rally has come on weakening participation with money being funneled into ever fewer stocks while key sectors are struggling and nearly 70% of $SPX components are trading below their January highs despite tax cuts, record buybacks and positive economic headlines.
Given historic mid term seasonality and current subdued volatility above its long term trend the current calm in markets may be subject to some testing this summer and fall. If the test turns out mild new broader market highs may still come, yet a break below February highs may severely challenge the long term trend of this bull run and these current market mysteries will have presaged trouble to come.
Related Reading: Bull Rebuttal