The Humpty Dumpty Market

X-Factor Report, 28 April 2014

by Lance Roberts, Streetalk Live

“All the king’s horses and all the king’s men could not put Humpty Dumpty back together again”

Despite a slate of better than expected earnings technology giants like MSFT and AAPL, the markets could not muster enough strength to break out of the trading range that began in February. Over the last couple of weeks I have been updating the chart below detailing what may potentially be an intermediate term topping process.

As shown in the lower part of the chart the markets remain in a confirmed sell signal that was triggered in late January. While the sideways consolidation of the market has kept the “bullish” sentiment alive – the internal deterioration of the markets has silently continued.

The following piece from Arthur Hill, via StockCharts, was most interesting:

How Is The S&P 500 Even Up This Year

The S&P 500 is a market of stocks and these stocks can be grouped into different industry groups and sectors. Using the sectors for a sum-of-the-parts analysis, it is clear why the S&P 500 is up over the one-month, three-month and year-to-date timeframes. Ok, the gain is not that much, but the S&P 500 was still up around 1% year-to-date on Friday morning (11AM). Note that $SPX finished 2012 at 1848.36 and a close below this level is needed to turn negative for the year.

The chart below shows year-to-date performance for the S&P 500 SPDR and the nine sector SPDRs. The numbers above each bar show the sector weightings in the S&P 500. Note that I added the weighting of the Telecom sector (2.5%) to the Technology SPDR weighting (18.45%) because Verizon, AT&T and Century Link are part of XLK. This combination weighting puts XLK over the 20% threshold and makes it the biggest sector.

Eight of the nine sectors are up year-to-date with the Consumer Discretionary SPDR the only sector with a loss and the only sector actually weighing on the market year-to-date. Even though the Technology SPDR, Industrials SPDR and Finance SPDR are underperforming this year, they are still up and have yet to actually weigh on the S&P 500.

Relative weakness in these key sectors is a concern, but the broader market is still in good shape as long as the majority of sectors show gains. Weakness will hit the S&P 500 when sectors representing over 50% of the market start breaking down. Right now only one sector can be considered weak: consumer discretionary. The next chart shows the equal-weight sector ETFs from Rydex and the picture is similar.

That analysis is why we have, to this point, continued to maintain our allocation to the markets. While there are certainly many things to be concerned about, the markets have done nothing “wrong” at this point to warrant reducing asset allocations and increasing cash.

However, there are a couple of very notable warning signs that we should be aware of. The first is that while we focus on the S&P 500 as our primary index, the markets that have been the leaders of the rally to date have been the Nasdaq Composite and the Russell 2000.

If the markets are going to fail, that failure will be led most likely by the previous leaders. Therefore, the fact that both of these markets are in the process of completing a market topping process is concerning. A failure of long term support, as shown in the two charts below, will likely lead to much deeper corrections including the S&P 500.

One of the things that I like to keep a watch on to judge the level of “risk appetite” in the market is the ratio of between High-Yield (Junk) Bonds and US Treasury Bonds. When investors are chasing risk, money flows into assets like the US Stock Market and the riskiest of bonds that pay the highest yield. If money is flowing faster into risky bonds rather than the safety of treasury bonds then we should be seeing similar behavior in the stock market which would confirm advancing prices.

However, as shown in the next chart, even at the S&P 500 was making new highs this year money has been leaving the “risk” trade. This bearish divergence in between the markets and bonds is an important warning sign as both bonds and stocks cannot be correct.

If the HYG/TLT spread confirms a new downtrend by breaking to new lows, then the risk will be that the stock market will likely breakdown as well.

Furthermore , the deterioration of the number of stocks hitting new lows shows a deterioration in the underlying “momentum” of the market. As you can see in the chart below, deterioration can begin sometime well before the actual peak but the result is inevitably the same.

Lastly, the markets are now beginning to price in the probability of a more severe correction as shown by the total put-call ratio below. The last time that the ratio was climbing off such a suppressed level was during the topping process heading into the summer of 2011. That process ended with a very rapid 19% decline.

The key point here is that while the market has currently done nothing wrong, doesn’t mean that it won’t. We need to continue paying close attention to developments as they occur.