Monday, April 7, 2014

Dive in Momentum Stocks Resumes

by Pater Tenebrarum

Nasdaq Takes a Hit, Rotation Into 'Safe' Sectors Continues

On Friday momentum stocks sold off with some verve again after the release of the payrolls data. Since the latter were actually quite close to the expected number, they cannot really have been the trigger of the sell-off (in other words, it would probably have happened regardless of the data). A few weeks ago, Charles Biederman of TrimTabs warned that the upcoming tax season could lead to some selling, but there is also the presidential cycle to consider. If the market continues to follow this particular cycle model (it has actually done so year-to-date), it should decline from an April high into an October low. What makes the recent market action interesting is that there continue to be multiple divergences in evidence between different indexes:

Russell 2000 Index, NDX, DJIA and SPX – the former two have been in sync, but have diverged from the other indexes. There are many more intra-market divergences between different sub-sectors that have been put in place over recent months.

Two examples illustrating the weakness in momentum names are PNQI (internet power shares) and BBH (a cap-weighted biotechnology ETF). These two were previously among the strongest sectors.


PNQI is closing in on its 200 dma – click to enlarge.


BBH is likewise about to meet with its 200 dma – click to enlarge.

There has been rotation from stocks perceived as risky into stocks perceived as 'safe', such as utilities and tobacco stocks. The ratio of XLU to QQQ has been rising strongly since making a low in mid January. In other words, there have been signs of intra-market deterioration since January already, but since early March they have become a lot more pronounced. This happens to coincide with the beginning of the Fed's 'tapering' of QE3, which may or may not be coincidence.

XLU-QQQ ratio

Utilities rise strongly vs. QQQ (an ETF replicating the performance of the NDX) – click to enlarge.

There is some empirical evidence that supports the idea that there may be a connection between this change in market character and the decrease in monetary pumping (small as it is). Previous pauses in the Fed's extraordinary policy measures have been followed by fairly sizable corrections on both occasions, and the market only regained its poise once new measures were either announced or implemented (QE2 was preceded by an 'announcement effect').

The market even rose after 'Operation Twist' went into effect, although this measure didn't increase the money supply directly. However, it was implemented around the time of the ECB's announcement of its then upcoming 3-year LTRO financing for European banks, and started just as a severe phase of the sovereign debt crisis in the euro area was peaking.

The next chart illustrates the situation – both shortly after the end of 'QE1' and 'QE2', the market started to crumble. This time, the SPX is only just off a record high, as the index has held up relatively well due to the above mentioned rotation. The fact remains though that the market's leading stocks and sectors are in trouble.

SPX and QE

The SPX with various monetary pumping measures by the Fed indicated (via stocktwits) - click to enlarge.

Sentiment Data

One side-effect of the fact that there has so far been rotation rather than a market-wide sell-off is that there has so far not been much deterioration in bullish sentiment. The Investors Intelligence poll's bull-bear ratio has however put in a bearish divergence with the SPX at its recent peak:


The II bullish consensus remains at a historically very high level, but has recently diverged from prices (it seems to be following the momentum sectors rather than the broader market) - click to enlarge.

Along similar lines, the sentiment microcosm represented by Rydex ratios has yet to 'catch up' with the decline in momentum stocks. Here is a long term chart we have shown before, which summarizes the situation. The bear/bull ratio remains at its lowest level since 2000, while money market assets are stuck at levels last seen in the late 1990s.

In short, because the broader indexes mask the weakness in the momentum sectors, Rydex traders have yet to desert the market to any noteworthy degree. They are in fact also rotating between sectors (the hitherto most popular sector fund biotechnology has lost approximately 15% of its assets recently, so the assets of other bullish sector funds must have increased).


Stocks and Rydex assets – click to enlarge.

Update on the Modified Davis Method

A few words on the Modified Davis Method (MDM), which was originally explained and presented by Frank Roellinger here. Below is a weekly line chart of the Russell 2000 since the fall of 2012, compared to the 'trigger line', i.e. the trailing stop level at which the methodology will issue a sell signal.

As of March 28, the trigger level was at 1,137.04 points, not very far from the current level of the index. The probability that a sell signal will be issued is therefore quite high at the moment. Note however that the index came close in January already, but ultimately missed the trigger line by a few points, so one can obviously not rule out another close shave just yet.

Modified Davis Method-RUT with sell points

The Russell 2000 index with the sell trigger line of the Modified Davis Method – click to enlarge.

It is only a very simple trend-following method, but it has handily outperformed the indexes. The chart below shows the long term performance (since 1960) of the SPX and the Russell 2000 (the Russell index was created in 1979, prior to that the Value Line Geometric index is used) without dividends or dividend reinvestment, compared to the trading result of the system (which is either 100% long, 50% long, 50% short or – very rarely – not invested at all). Interest income that could have been earned on the cash portion during the times when the system was either only 50% invested or 100% in cash is excluded as well. It is assumed that $100,000 were invested at the beginning of the period (buy & hold in the indexes). While past results cannot guarantee that it will work similarly well in the future, the track record to date is quite impressive.

modified davis, return

MDM vs. SPX and RUT (VL geometric index prior to 1979) – click to enlarge.

Money Supply Growth and Stocks

There is a variable lead-lag time between the growth rate of money TMS-2 and stock market trends. In 2007, the lag time between the slowdown in money supply growth and the market peak was longer than in 2000, but  keep in mind that US house price indexes peaked already in mid 2006. It is possible that a higher threshold level will be relevant this time, given the weakness of the economic recovery (which reflects the capital consumption of the preceding credit boom periods, as well as the decision to arrest the liquidation of malinvested capital by means of monetary pumping at a very early stage of the process).


TMS-2, simplified version without memorandum items, year-on-year growth rate. In recent years crossing below the the 5% threshold was soon followed by trouble in asset prices – click to enlarge.

We have employed a simplified version of TMS-2 that excludes memorandum items, as they only represent a tiny percentage of the total money supply and are not updated as frequently as the main components. As a result, the chart is slightly more up-to-date, while the difference to the complete version is actually barely noticeable.

TMS-2 Growth and SPX

The same chart with the SPX overlaid. Money supply growth accelerations and slowdowns tend to lead trends in the stock market, but the lead-lag times vary. Note that while the peak in the y/y money supply growth rate was higher after the collapse of the Nasdaq bubble than after the 2008 crisis (due to the lack of inflationary lending by commercial banks after the latter), it has remained at very elevated levels for a longer period after 2008. However, just as has happened prior to previous major market peaks, it is clearly trending down now – click to enlarge.


It is not possible to tell whether a sell-off from a recent high indicates merely a short term correction or the beginning of a bigger downtrend, as both initially look similar. However, we know from the presidential cycle model, the recently recorded extremes in sentiment data and the slowdown in money supply growth that one must pay close attention at the moment.

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