Consolidation or Topping Pattern?
From a technical perspective, the recent trading range in the US stock market is not really telling us much about what to expect next. It is possible to regard it as a drawn-out consolidation pattern prior to a renewed surge, but it is just as likely that it is in fact a distribution pattern.
We have discussed the sentiment backdrop a number of times recently. Although the public exuberance that was visible in 2000 is largely absent, virtually every other measure of sentiment, whether in terms of positioning, surveys or of the anecdotal variety, seems stretched like rarely before. In many ways it is the exact opposite of what was seen near the 2009 lows. Anecdotal evidence includes items like the stock market valuation accorded to a company that owns four mobile grilled cheese dispensers in the OTC market (a cool $100m.), which is discussed in more detail by Barry Ritholtz here.
However, sentiment data have looked quite stretched for more than a year already (although they have reached their greatest extremes to date late last year and early this year). This hasn’t kept the market from advancing, but there may be some information in the fact that sentiment has not (at least not yet) turned cautious in the course of the recent trading range. From experience, trading ranges that are destined to be resolved by upside breakouts tend to involve a deterioration in bullish sentiment.
Today we want to briefly look at trend uniformity and a few other simple technical data points though. It should be noted ahead of this exercise that since the market remains quite close to its highs, there are of course quite a few sectors and individual stocks that continue to look technically strong at the current juncture. The breakdown in energy stocks due to falling oil prices has gone hand in hand with a revival of sectors that looked weak previously, such as consumer discretionary stocks.
Below is a weekly chart of the S&P 500. In recent months, a noticeably divergence between prices, the RSI and MACD has formed on a weekly basis. This is noteworthy mainly because it hasn’t happened in quite some time – the last time a strong weekly price/RSI divergence was recorded was just before the hefty correction in summer of 2011 commenced.
This time, the divergence is more glaring, insofar as it has been put in place over a time period of more than a year:
Weekly divergences between price and RSI and MACD in the SPX – click to enlarge.
Next a brief look at trend uniformity, or rather, the lack thereof. Usually trend uniformity tends to break down as an advance reaches its late stages. The reason as far as we can tell is that market advances tend to near their end when money supply growth rates decline below a certain threshold (this threshold is unfortunately not fixed – if it were, it would be very easy to forecast stock market turning points).
When this happens, there is not enough additional free liquidity available to bid up all, or most prices, so buyers tend to focus on an declining number of equities. The chart below shows three ratios: small caps (Russell 2000 Index/RUT) vs. big caps (SPX), tech stocks (NDX) vs. SPX and the broad market in the form of the NYSE Index (NYA) vs. the SPX.
The RUT-SPX, NDX-SPX and NYA-SPX ratio – click to enlarge.
Over the past year, the performance of small caps and the broader market has steadily deteriorated against that of big caps. By contrast, big cap momentum stocks as represented by the NDX have for the most part outperformed the broader big caps sector. In short, trend uniformity has steadily broken down over the past 12 months. Lately all three trends have begun to stall out a bit. It remains to be seen whether the rush into momentum stocks late last year will prove to be meaningful, but a similar phenomenon has been observed near prior market peaks.
Lastly, here is a chart of the NYSE index with its new high/new low differential (NH/NL) and the cumulative advance decline line (A/D line). The cumulative A/D line has recently made a new high; this is usually regarded as a positive, but it nevertheless represents a divergence with prices. Still, normally this measure tends to peak ahead of prices, and not after the price peak, so this indicator is still favorable to the bullish case at this point. The NH/NL differential meanwhile has deteriorated along with prices.
The NYA is probably a much better representation of the average portfolio return than narrower indexes like the NDX or the SPX, as most stock market portfolios tend to be diversified across a large number of industries, sub-sectors and market caps.
What makes this interesting is that although the broader market as represented by the NYA has put in what – so far anyway – appears to be a double top in July and September and has achieved no progress since the secondary peak in September, the enthusiasm of traders and stock market advisors has continued to increase since then.
In other words, instead of bullish sentiment weakening a bit in line with the broad market’s lackluster performance, it seems to have followed the narrower indexes that have managed to put in marginal new highs since the October correction. It seems to us that this makes a further advance much less likely, at least on a medium term basis.
In the short term, there is always the possibility of another marginal new high being reached, since the market is not too far away from new high territory and the major European markets have strengthened considerably recently (note however that this strength was not confirmed by peripheral European markets).
NYSE Composite Index (NYA) daily with NH/NL differential and the cumulative A/D line – click to enlarge.
In light of the market’s valuation (in terms of the median stock, the market has never been more highly valued than now, not even at the year 2000 peak) and extremely lopsided sentiment, the divergences and the lack of trend uniformity discussed above should be seen as signs that caution continues to be warranted.
On the other hand, US money supply growth still remains relatively brisk, as commercial bank lending has accelerated just as “QE” has been discontinued. As we have recently pointed out, in the euro area, money supply growth is accelerating quite a bit now, so there should soon be a revival in aggregate economic activity there. Over the past year or so, the European markets have tended to react positively to improving macro-data, and may therefore indirectly lend support to the US stock market.
On the other hand, the monetary pumping game is getting a bit long in the tooth by now; if the economy’s pool of real funding has suffered substantial enough damage, it may no longer suffice to drive stocks even higher. All the additional pumping that is in the offing may well already be discounted in prices. We certainly wouldn’t ignore technical warnings because of it.