When Fundamentals And Technicals Clash

Trend Model Signal History

 

What would your expectations be for US equities? Would you have predicted that the SPX would crater by 2% on Thursday and continue to decline Friday?
What is puzzling for fundamental investors is that the stock market retreat last week has been singularly lacking in fundamental underpinnings. Most importantly, the two principal drivers of stock prices are E and PE. With respect to the former, the earnings outlook remains positive as Ed Yardeni reported that Street expectations continue to get revised upwards:

More timely data came from Marc Chandler  summarized the tone the FOMC statement this way:

The FOMC statement made it clear that while the downside risk to inflation had lessened, the slack in the labor market favored continued accommodation, and the low Fed funds rate was anticipated to continue for a considerable period. There was one dissent over that forward guidance, but no one, even those that have publicly argued the Fed was slipping behind the curve, called for a rate hike. The course that Bernanke put the Fed on remains intact.

 

With regards to the capitalization rate for earnings, the 10-year Treasury yield ticked up 6 bp on the week, but the 5-year yield declined. Steepening yield curves are a typical characteristic of a robust and growing economy. That`s good news, right?

So why did the stock market freak out on Thursday and Friday?

A technically driven decline
The only reasons that I can cite for the decline in the major US equity averages are based on technical analysis. As I pointed out last weekend (see Global growth scare = Trend Model downgrade ), I suggested that Mr. Market is anticipating a global growth scare. As a result, I downgraded the technical signal for my Trend Model for the following technical reasons based on inter-market analysis:

• Falling commodity prices
• Weak equity prices in Europe

(There were many charts in the analysis from last week, but I won`t repeat them here but you can review them at this FT Alphaville highlighted BCA Research`s observation that small caps are lagging their large cap counterparts on a global basis:

BCA postulated that it was because smaller companies are more sensitive to rising labor costs, which would be negative for wage inflation, a measure closely watched by the Fed:

In the interim, the message is that small cap labor expenses are likely to be far more punitive than wage costs for large businesses. This is confirmed by the sharp rise in the household employment survey relative to the establish- ment survey this year. The former includes smaller companies and the self-employed, and when it rises faster than the payroll survey it is a signal that wage pressures are building among smaller firms. Thus, small cap profit margin pressure will become more acute earlier than it will for large caps.

 

Several days later, McCrum`s FT Alphaville colleague Cardiff Garcia tweeted that wage growth was weak across advanced economies:

What`s the real story? How can wage growth be weak and small caps be pressured by wage growth? Is this a case of the technicals (small cap underperformance) telling one story and the fundamentals (wage growth) telling another?

There is always a divergence somewhere
Today, US equities continue to experience negative divergences. As an example, Mark Cook uses a proprietary breadth measurement to gauge the health of the stock market and he is seeing conditions similar to the tops in 2000 and 2007 (emphasis added):

Mark Cook, a veteran investor included in Jack Schwager’s best-selling book, “Stock Market Wizards,” and the winner of the 1992 U.S. Investing Championship with a 563% return, believes the U.S. market is in trouble.

The primary indicator that Cook uses is the “Cook Cumulative Tick,” a proprietary measure he created in 1986 that uses the NYSE Tick in conjunction with stock prices. His indicator alerted him to the 1987, 2000, and 2007 crashes. The indicator also helped to identify the beginning of a bull market in the first quarter of April 2009, when the CCT unexpectedly went up, turning Cook into a bull.

What does Cook see now?

“There have been only two instances when the NYSE Tick and stock prices diverged radically, and that was in the first quarter of 2000 and the third quarter of 2007. The third time was April of 2014,” Cook says.

In simple terms, as stock prices have gone higher, the NYSE Tick has moved lower. This divergence is an extremely negative signal, which is why Cook believes the market is losing energy.

In fact, the Tick is showing a bear market, which seems impossible considering how high the market is rising.

“The Tick readings I am seeing (-1100 and -1200) is like an accelerator on the floor that is pressed for an indefinite amount of time,” Cook says. “Eventually the motor will run out of gas. Now, anything that comes out of left field will create a strain on the market.” Since the CCT is a leading indicator, prices have to catch up with the negative Tick readings.

“Think of a dam that has small cracks that are imperceptible to the eye,” he says. “Finally, the dam gives way. Eventually, prices will go south, and the Tick numbers will be horrific.”

Cook is also concerned that the market is acting abnormally. “It’s like being in the Twilight Zone," he says. “Imagine going outside when it’s raining and getting sunburned. That’s the environment we’re in right now.”

 

Josh Brown  aptly wrote last week that there is always a divergence somewhere and sometimes they matter and sometimes they don`t:

The thing is, there is always a divergence. Sometimes they matter, sometimes they don’t. Sometimes one key divergence that was extremely important ends up meaning exactly zero the next time around. A single divergence, in and of itself, has all of the reliable predictive power of a bowl of chicken bones spilled out across the table.

And since no one has ever been able to prove otherwise – isolating a single divergence and showing a consistent win rate based on following it – you’re going to have to take my word for it.

 

My view is that unless this decline has a fundamental underpinning, any pullback is likely to be ephemeral. Without fundamental support, the downside for any market weakness is going to be highly limited. The last time the market declined in any major fashion was 2011. Recall that episode was driven by the combination of a eurozone debt crisis and fiscal uncertainty due to a political impasse in Washington.