- Measures of risk appetite such as the ratio of consumer discretionary stocks to consumer staples and small caps to large caps are in decline, pointing to a changed market environment.
- Participation in this advance is thinning, as fewer and fewer stocks are making new highs with the market.
- These are the type of market conditions in which the market tops form and at the least provide juicy opportunities on the short side.
A bear market is defined as a 20%+ pullback from peak to trough, by this definition, we are in our second cyclical bull market since March 2009. In May 2011, the S&P 500 peaked at 1371 before finding a low at 1074 in October 2011. This was a 21.7% move lower.
Some of the catalysts for the move lower were the Federal Reserve ending QE2, weakness in European financial markets specifically periphery countries, the downgrade of the US by rating agencies, and Congressional dysfunction. With these factors, the Federal Reserve stepped in once again with QE3, the stock market stabilized trading in a range until early 2012 before resuming its climb higher. From the October 2011 low, today the stock market is almost 100% higher in a little more than three years time.
There are some similarities between today’s market and 2011, such as the Federal Reserve ending its balance sheet expansion and an overheated, overbought stock market. Internally, both markets were showing signs of distribution with fewer and fewer shares participating in the broader market’s advance. Both markets have had signs of risk aversion such as small caps underperforming and money flowing into more defensive areas of the market such as utilities and consumer staples.
Many institutions by mandate must have a certain percentage of assets in stocks, thus when they grow cautious they move into defensive names. Outperformance in these names is considered a warning sign that institutions are becoming bearish. However, one key difference between then and today is the performance of yields. In May 2011, the ten year yield was at 3.3%, while today it is at 2.3%. The lower yields are surprising given that the economy is in much stronger shape today based on employment figures, industrial production, corporate balance sheets, and consumer spending compared to May 2011.
The lower yields are less a function of the domestic economy and more due to global weakness while Europe, Japan, and China are struggling with declining growth, making additional stimulus imperative, while the US is now tightening policy. These factors have also contributed to the rapid appreciation in the value of the US dollar. So far, the US market has been immune to overseas weakness.
This is probably the number one vulnerability of today’s market, the combination of overseas weakness and US dollar strength is a powerful headwind for the revenues of multinational companies. It is remarkable that they have weathered this storm so well, so far. As detailed above, one sign of a bull market is healthy risk appetites. Two effective measures of risk appetites are the performance of consumer discretionary stocks to consumer staples and small caps to large caps. Both of these are pointing to a changed market landscape. Below are the five year versions of these charts compared to the S&P 500.
Consumer discretionary stocks are typically the fastest gainers in the early portions of the market cycle, as increased spending benefits them the most. Similarly, during a recessionary period, consumers cut this type of spending first. In contrast, consumer staples produce products such as diapers, toilet paper, soap, cleaning supplies, etc., that consumers must purchase regardless of the market environment. Thus, it is considered a defensive segment of the market.
The relative performance of these two areas of the market is clearly indicating that risk appetites are waning, despite the recent move back to new highs. The same thing happened in the previous market top in 2007, when it rolled over making lower lows in early 2007, preceding the market top by about six months.
The ratio between small caps and large caps is also communicating a similar message. This ratio actually rolled over as the stock market was making new highs in the latter part of 2007, indicating that the new high was coming with diminished participation. Only when divergences such as this are present, is it prudent to bet against a strong market. Importantly just because divergences are present, is not a causal indicator that stocks will top. However, it is a necessary ingredient for a market top.
This relationship is revealing because small caps are more leveraged to economic growth, when the market is optimistic about growth, small cap stocks are bid up in anticipation, as they benefit the most. The converse is true as well, small cap stocks are sold off first, when growth is expected to disappoint, due to their weaker balance sheets and higher interest rate expenses. This makes them more vulnerable when the cycle turns.
Additionally, sustainable market advances are on the backs of individuals buying individual stocks and holding them. The majority of small cap stocks are purchased in this manner, while large cap strength is often a function of money moving into ETFs or futures, quick trading vehicles, where turnover is rapid. When small caps are leading, it can be said that inflows into the market are due more to individual stock buying, while when large caps are leading, inflows are dominated by ETFs and futures.
Another alternative method to gauge market health is to look at internals via the cumulative advance-decline line. This simply is a running total of the difference between the stocks going up and the stocks going down, with the running total tabulated. This is another way to examine the performance of individual stocks as opposed to the market cap or price weighted indices.
Below is the New York Stock Exchange Cumulative Advance - Decline Line over the past 10 years:
The above chart shows the deterioration in the number of shares participating in 2007 as the market topped. In 2007, as the market made a higher high in October, the NYAD cumulative line notably did not follow making a lower high. Recently, this measure has failed to confirm the new highs of the S&P 500.
Again, these market statistics do not mean that stocks are going to start tumbling tomorrow. It does mean that market conditions are ripe for nasty surprises on the downside indicating that markets are overvalued. Many stocks are in clearly defined downtrends, and there are as many opportunities on the short side as the long side. Justin Mamis in his seminal work The Nature of Risk explained that 1 out of 3 stocks prior to the overall indexes topping, 1 out of 3 top with the general market, and 1 out of 3 top keep making new highs until they are finally taken down by the bear market.
The market has been climbing steadily higher since late 2011, breeding complacency amongst investors and leading to various excesses, in terms of risk taking. Volatility is at lows and margin debt is at highs. This combination, along with lagging internals, makes stocks vulnerable.