Friday, April 11, 2014

Nasdaq Suffers Worst Day Since 2011

by Pater Tenebrarum

The Shellacking Continues

It could well be that the divergences between various market sectors and indexes we have recently pointed out will in hindsight be recognized as having constituted a major warning signal. Of course the correction is so far not big enough to make that determination, but it may be worth taking another look at the comparison chart we recently posted:


NDX, Russell 2000, SPX and DJIA compared. We have added vertical lines that align with the peaks in the indexes – as can be seen, they all peaked at different points in time, spread over a lengthy time period – click to enlarge.

Interestingly, we have seen no particular 'reason' cited in the media for Thursday's wave of selling, which is rare and should alarm bulls. It is usually a bad sign when a market declines sharply without there being an easily identifiable trigger event. Usually there is almost always something that serves as an easily digestible sound bite to 'explain' the action to us mere mortals.

Here is an update of the 'safety versus growth' indicator we showed previously, namely the XLU-QQQ ratio. When this ratio rises, it indicates that investors are rotating out of 'risky' growth stocks into 'safe' high yielding stocks the earnings of which are considered relatively immune to economic downturns. One could construct similar charts using e.g. tobacco stocks instead of utilities or other permutations on the same theme, but this chart should suffice to make the point:

XLU-QQQ ratio

The XLU-QQQ ratio rockets higher, making yet another new high for the move – click to enlarge.

A Closer Look At Biotechnology

However, we want to take the opportunity to look at a specific sector this time, namely biotechnology stocks. Biotech has been a major upside leader, along with 'social media' and other internet stocks and a few other sub-sectors.

In terms of Austrian capital theory, R&D activity is certainly a very early stage of production, precisely the type of business activity that will tend to look more profitable when interest rates are artificially suppressed and at very low levels. It will therefore attract a lot of investment – much of which will later turn out to be malinvestment, as the economy can actually not support all the projects that are initiated in the higher stages of the capital structure.

It is quite noteworthy that this sector has assumed the mantle of downside leadership lately – it has declined by nearly 19% from its late February peak. Of course this may still turn out to be a temporary, if very sharp, correction. However, there are a number of warning signs to ponder. There has e.g. very rarely been a Rydex sector fund attracting a similar amount of bullish enthusiasm. More than 37% of all Rydex sector assets were invested in the biotech fund at its recent peak. This mirrors the general sentiment toward biotech stocks quite nicely. The sector has been a veritable magnet for capital.


Major crime scene: the  Nasdaq Biotechnology Index - click to enlarge.

Below is a chart showing the enormous growth in assets of the above mentioned Rxdex biotechnology fund over the past two years. Partly this growth was of course due to the rise in the fund's value. However, there have also been steady cash inflows, and early investors held on for the bulk of the ride. Recently assets have of course retreated, but in a putative worst case scenario there may be a lot still left to go:

Rydex Biotech Fund

At its recent peak, the Rydex biotech fund had attracted huge amounts of money and represented over 37% of all bullishly positioned Rydex sector assets – click to enlarge.

A Look At Production Index Ratios

Long time readers know that we often look at the ratio of capital goods vs. consumer goods production. While one must take all such statistical data with a grain of salt, they can often be useful as long as they are consistent over time.

In this particular case, we are trying to determine whether an expected effect of monetary pumping can be discerned in the data on production – namely, the above mentioned redirection of factors of production into higher stages of the capital structure (capital goods) to the detriment of lower stages (i.e., consumer goods). If this shift is not supported by a commensurate increase in real voluntary savings, a production structure that ties up more and more consumer goods while releasing fewer and fewer of them results, without a concomitant change in society-wide investment-consumption preferences.

The suppression of interest rates by means of monetary pumping distorts relative prices and therefore falsifies economic calculation. It signals that there are more real savings available than there really are. Such a production structure is inherently unsustainable and the situation invariably leads to an economic bust, usually when monetary policy begins to be tightened.


The ratio of capital to consumer goods production has recently begun to stall out at a historically extremely high level – click to enlarge.

In addition to the chart above, we have also made a chart of the annual rate of change of the ratio. As can be seen, it too tends to drift down shortly before recessions and it is currently clearly in 'red alert' territory:

Ind-prod-buseq-consgoods ratio-y-y ROC

Capital to consumer goods production ratio, annual rate of change. It exhibited a lag in 2008 and may well exhibit a lead this time around. In any case, it is close to a level  that normally indicates an economic bust is not too far away – click to enlarge.

Clearly this amounts to yet another warning sign, and if we put it into context with the recent plunge in biotechnology stocks (with many companies in the sector active in a very high stage of the economy's capital structure) it becomes potentially even more relevant.

There is however one caveat to consider: while y/y money supply growth has slowed down quite a bit, it is still at a very high level historically. It may yet re-accelerate, depending on upcoming monetary policy decisions, private sector credit demand and the lending decisions of commercial banks. However, if the economy's pool of real funding has sustained severe damage, it is conceivable that even a re-acceleration in monetary pumping won't help. We will have to wait and see what transpires, since we obviously have no means of 'measuring' the economy's pool of real funding. We can only make tentative inferences from the available data.  Also, many other indicators that normally serve as leading indicators of recession are not flashing red just yet.

Keep in mind however that when an artificial inflationary boom comes to an end, there is often a very sudden change in conditions. At times this is presaged by a sharp decline in the stock market, sometimes the market only declines once the economy's difficulties are fairly obvious (in recent years the latter has actually occurred more frequently). Businessmen often describe the end of the boom with expressions such as 'it was as though someone had suddenly thrown a light switch'. In other words, it is possible that there will be very little warning – the economy could well move from mild expansion to contraction very quickly when the time is ripe. The Citigroup 'economic surprise index' is very volatile and certainly not a reliable recession indicator, but it is one of the data series currently indicating that the stock market is not reflecting economic conditions properly; this is to say, it incorporates very optimistic expectations, while the same optimistic consensus expectations held by economists have recently been continually disappointed by the release of 'weaker than expected data':

Citi Surprise Index

Citi's 'economic surprise index' is at its most negative level since mid 2012, and has diverged rather noticeably from the stock market recently – click to enlarge.


Contrary to those eager to 'catch falling knives', we would suggest it is actually a good time to be cautious, short term bounce possibilities in 'oversold' sectors notwithstanding. Risk remains very high.

Addendum: 'Abe Bliss' Likely to Wane Further

Shinzo Abe is probably on the phone with Mr. Kuroda already, urging even more excessive monetary pumping measures. He cannot be very happy about recent market moves, as 'Abe bliss' is likely to nosedive right along with the stock market:


The Nikkei violates a short term support level. Is the Abenomics mini-bubble already expiring? - click to enlarge.

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