Market Signals Are Bearish

Several market signals point in a bearish direction lately. Lower Treasury yields, slumps in consumer discretionary, homebuilding and Chinese stocks, and higher expected market volatility are disquieting.

During bull markets, most stocks appreciate.  There are always a few losing stocks during a bull market, and some companies run into significant company specific problems. But a rising tide normally raises all seaworthy boats.  Experienced investment managers like to say “they have not seen investors lose a lot of money in bullish periods and they have not seen investors make much money in bearish periods.”

If we were newspaper reporters investigating a story, standard operating procedure would be to talk with a variety of sources to either confirm or refute the story line. Multiple sources of confirming information would boost our confidence in the validity of the underlying story line.  The story should add up.
 
So far this year, the bull market story line has not added up. For example, the technology sector has underperformed the Standard & Poor’s 500 by over 20 percentage points year-to-date. Small-capitalization growth stocks have negative returns on the year, while large-cap value recently touched new highs. 

Our firm’s Delta Market Sentiment Indicator (MSI), which measures roughly 3,600 stocks, turned bearish in early May.  The average stock is in a bearish trend.  We documented some of the inconsistencies in market sector price movement in the last several Delta Wealth Accelerator newsletters.

There are an increasing number of gaps in the bull market story. This is a developing story about a market undergoing a transition.  What is unclear at the moment is if the transition is from bull to a new type of bull with different leadership, or from bull to bear.
 
Dow Jones Industrial Average and the Russell 2000 (IWM), or the exchange-traded fund that tracks it. Large-cap global stocks versus small cap stocks – is the U.S. economy not accelerating as expected?

  • Small stocks generally derive a majority of their revenue domestically compared to large-cap stocks, which earn nearly 50% of it abroad. The small-cap benchmark Russell 2000 is trading below its 200-day moving average (long-term trend line) for the first time since November 2012.  Underperformance in the Russell 2000 suggests less than expected growth in the U.S. economy.
  • Small-caps are considered more risky and volatile than large-caps. Increasing relative strength in large-caps versus small-caps indicates a risk-off trade – meaning investors tilt toward less-risky issues – and a rising equity risk premium, here measuring how much higher a stock index’s return needs to be above risk-free long-term Treasury bonds. Below is a chart showing the recent separation, or gap, between the price action of the large-cap Dow Jones Industrial Average and the Russell 2000. 

 

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S&P 500 versus the Consumer Discretionary Sector ETF (XLY):

  • 70% of U.S. gross domestic product is driven by consumption – namely, consumer spending.
  • U.S. April retail sales were below expectations (reported May 13 at 0.1% versus 0.3% expectation and 1.5% prior). Wal-Mart Stores (WMT) reported less than expected earnings and second quarter guidance May 15 with no extreme weather to blame.
  • The consumer discretionary sector – nonessential items ranging from autos to refrigerators to clothing – can be a leading indicator for overall stock market. Consumer discretionary continues to trade lower from its March 7 high.

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S&P 500 versus 10-year Treasury rates. Normally, when economies begin to gather positive momentum, interest rates rise. Lately, the 10-year Treasury rate reached a new low for the year. Declining 10-year rates could indicate weaker-than-expected economic growth and a possible flight to safety out of risk assets (stocks) and toward safety (U.S. Treasuries).

 

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Homebuilder Stocks ETF (XHB) versus the S&P 500. Interest rates are falling.  Employment and household formations are rising.  This should make for a strong housing market. Yet the homebuilder stocks in this ETF are trading down for two months. The jobs and the housing market are two of the most important legs supporting the economy. A weak homebuilding sector is not a bullish indicator.

 

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China Stock Market ETF (PGJ) versus the S&P 500. The Chinese stock market as measured by the PowerShares Golden Dragon China Portfolio ETF (PGJ) is down more than 20% from high to low this year. Technically, the ETF signals that the Chinese stock market is in a bearish period.  The chart below shows the gap that recently opened between the Chinese stock market and the S&P 500.

 

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VIX spot price versus VIX futures prices? The Chicago Board Options Exchange Volatility Index, or VIX, measures how much trading turbulence the market expects in the S&P 500, as seen by S&P options. An increase in volatility suggests a riskier market. Valuations of the VIX futures are based on expected values of VIX at the expiration date in the future, rather than the current or spot VIX value.

  • The spot value of the VIX trades near 12-month lows. The VIX is currently 12.0. In 30 days, however, the VIX futures show a price of 14.0. In 90 days, the VIX is expected to be 15.7.
  • Options traders expect higher volatility in the next 30 and 60 days. Rising volatility is normally associated with investor uncertainty and lower equity prices on a rising risk premium.

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Nicholas Atkeson and Andrew Houghton are the founding partners of Delta Investment Management, a registered investment advisory firm in San Francisco, and authors of the new book, Win by Not Losing: A Disciplined Approach To Building And Protecting Your Wealth In The Stock Market By Managing Your RiskAdditional market commentary and investment advice is available via their websites at www.deltaim.com and www.deltawealthaccelerator.com

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