2 Problems for the Market

While the Standard & Poor’s 500 index has been in record territory for about a year, two warning signs suggest trouble ahead: a divergence between small and large stocks, and between consumer discretionary and consumer staples stocks. Should you be concerned?  

Since April 2013, the index has broken successively higher records despite loud disagreements among analysts and strategists about whether these levels are justified or not. Just this week, despite a few dips, the S&P 500 approached the psychological 1900 level.

After losing about half its value five years ago, the S&P 500 is now over two times higher than its worst point of March 2009. Yet despite this stunning rally, it is hard to find investors who are exuberant about stocks today like they were about Internet stocks during the dot-com frenzy, houses in the real-estate boom or gold when everything else seemed toxic.

This is not typical: When assets boom, people tend to jump in. But those who remember the infamously wrong-headed 1999 book Dow 36,000 are hard-pressed to find any book remotely as optimistic on the bestseller lists today.

So the rally grinds on, with or without the public’s conviction. The indifference with which investors greet these record levels is, paradoxically, bullish. Markets reach a peak when everyone is all-in and nobody is left to buy. Since there is still plenty of spare capacity to load up on stocks, the potential for further strength is undeniable.

But too much exposure to stocks is not the sole cause of market reversals. Things can take a turn for the worse if unexpected events scare people, or if confidence weakens when conditions deteriorate. The problem is that, by the time the scary stuff hits or weaker conditions become evident, it is usually too late. That’s why investors who are already skeptical scrutinize the market for clues of hidden dangers.

Some of those signals appeared in recent weeks in the form of sharp divergences between aggressive and defensive stocks.

Large-capitalization stocks and small-cap stocks, for example, have gone in opposite directions. To pessimists, this is a clear warning that the market is heading for trouble.

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Indeed, there is little evidence – actually, none – in the last 14 years that a market rally like this one can actually take place without aggressive stocks being at the forefront of performance.

A chart showing the difference between the total return (price gains plus dividends) Russell 2000 index of small-cap stocks and the total return S&P 500, to May 2000, shows how sharply small-caps underperformed large-caps. Apart from a few days here and there in the last 14 years where both measures don’t march in lockstep, this situation is truly unique.

This is worrisome because, generally speaking, small-caps need favorable economic and financial conditions to prosper. Their severe underperformance suggests that the market is convinced that those conditions are about to worsen.

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Similarly, very few instances exist when the general market breaks new records while consumer discretionary stocks underperform consumer staples. Consumer discretionary stocks are those of companies that people can live without (like Tiffany’s). They tend to do well when everyone is ebullient about the economy’s outlook.

Yet discretionary items don’t sell as well as staples that people still need to buy during economic downturns, like food and soap. Again, the discrepancy between a record-breaking market and the weakness of an aggressive equity sector like consumer discretionary is stark.

To be sure, other indicators paint a more benign picture.

Volatility, for example, remains remarkably low: There was only one day in the last month when the S&P 500 moved more than 1% in either direction. Inter-asset correlation, while still somewhat elevated, has so far remained stable. And interest rates, long expected to soar, have not moved much in months – the 10-year U.S. Treasury note has remained pretty much constrained to a narrow 2.50%-2.80% range since late January. 

Optimists shrug off the divergence between aggressive and defensive stocks as insignificant, while pessimists look at conditions that suggest calm and see them as a prelude to the proverbial storm.  It is impossible to say who’s right, but clearly the unusual conditions will keep investors on edge and uncommitted, even if the market continues to crawl to higher levels.

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Raul Elizalde is president and chief investment officer of Path Financial LLC Investment Management in Sarasota, Fla., where he writes the e-letter Straight Talk.

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