Picking up from last week’s article, I wanted to continue to develop the notion that the market is rotating out of growth and into lower beta stocks. In addition, some other signs of de-risking are developing. Finally, while the U.S. market is the best house in a bad neighborhood, recent economic developments this week have shown there may be termites under the U.S. flooring, which may be justifying profit-taking from market leaders as investors and managers de-risk their portfolios.
According to Sector Rotation Theory, a subject I’ve often talked about, defensive leadership has been a precursor for a market correction in years past. As I showed last week, we are seeing new leadership in the market with health care, consumer staple, and utility stocks outperforming. While last week I suggested that a rise in defensive stocks might not be a bad thing, combined with other indicators that we’ll review here, the de-risking process may have just been prolonged this time around due to late money entering the markets – late money that has decided to buy blue-chip, low-beta, and high yielding equities as opposed to growth stocks.
De-risking
Now that I’ve discussed the rotation, it’s time to look at other inter-market relationships that will shed more light on the de-risking taking place. Let’s start with market breadth. When few stocks are participating at new market highs, it’s a warning that internal strength is waning and private corrections have already begun in certain stocks. I use two measures to gauge this weakness. One is the percentage of S&P 500 stocks above the 50-day moving average (which is an intermediate-term tool) and the other is the percentage of S&P 500 stocks above the 200-day moving average. When these two indicators show divergences or roll over, I take note.
Percentage of S&P 500 Stocks above 50 Day Moving Average
The Percentage of S&P 500 stocks above their respective 50-day moving average has been sliding to lower highs while the S&P 500 has climbed to higher highs since mid-January. Currently, that number sits at only 63.8%. An early warning signal was registered in February when both the trend (blue line) and a top had formed (dotted black line) in the indicator. This indicator hints at intermediate-term distribution as fewer stocks participate in higher highs. The recent dip below 70% has triggered the second intermediate-term sell signal in the market since January.
Percentage of S&P 500 Stocks above 200 Day Moving Average
The percentage of S&P 500 stocks above their long-term 200-day moving average is used more in identifying significant turns in the market. The longer the indicator stays in overbought or oversold territory, the stronger the trend. You will also note that this indicator has stay well above 50% for a goodly portion of time over the past few years, highlighting the bullish period we find ourselves in for stocks. Here, I’m looking for topping patterns in the indicator to suggest an early sell signal. In the traditional sense of the indicator, a sell signal is formed when the indicator falls below 70%. Currently, at 86% of the S&P 500 above their respective 200-day moving average, the trend remains quite healthy long-term. A drop below 82% would be an early indication of a correction.
VIX and the Put to Call Ratio
Looking at the VIX, a measure of implied volatility that typically has an inverse relationship to the stock market, it indicates a possible divergence between the recent market highs and a rise in the indicator. Additionally, I see that the CBOE Index put to call ratio indicates that an overly bullish low was made on March 20th and has since receded. Along with the recent market correction, these two indicators are beginning to indicate some de-risking is taking place.
Small-cap Underperformance
The chart below shows the Russell 2000 index with a relative strength ratio of the index divided by the S&P 500. The signal this week indicates that the S&P 500 is now outperforming the small cap index after four months of underperformance to the more beta-affluent small cap index. Smaller companies are typically domestic-only companies. It would make sense that this index would outperform as the U.S. outperformed most of the other developed economies. Underperformance in small cap is just another indication of a rotation out of risky investments.
False Breakout
The last measure of concern is the recent false breakout in the S&P 500 above 1564. We were above that level for three days and have given it back. Today’s intraday high was 1562.60. As you can see from the short-term trend line, the hourly trend has broken and is now acting as resistance. This is another red flag to be concerned about. Intermediate-term support is now holding at 1542. A break there would signal a more meaningful correction is at hand. The S&P 500 would be in a better condition if the index can rally back above 1564.
Economics
This week’s weak economic reports for the U.S. have further compounded the issue of de-risking. ISM Manufacturing fell on Monday. ISM Non-manufacturing fell on Wednesday. Jobless claims reported a decent rise in claims on Thursday for last week and the private sector employment report slowed sharply. The economic reports this week do not bode well for the BLS jobs report data on Friday. While factor orders were up 3% in February, the data is a month old. The new orders portion of the ISM Manufacturing for March dropped off a cliff (57.8 to 51.4) and is more of a leading indicator on future economic activity.
Conclusion
To sum up what my indicators are telling me, we are in the midst of sector rotation. De-risking is taking place, but an outright exodus from the market has not happened. The trend of the overall market suggests distribution, but not correction. De-risking is a typical precursor to a market correction so caution needs to be warranted again. The last time we faced some of the similar indicators like momentum divergence and worries over Italy and the FOMC minutes only produced a 2.5% correction and a buying opportunity. At this stage of the game, I’m looking at any correction between 5-10% as a buying opportunity due to the Fed’s accommodative policy in addition to low commodity prices. Any near-term weakness in U.S. economics due to Spring Break and seasonal adjustments will likely be riposted by dovish comments and policy steps from Central Banks. Case in point: the Charlie Evans (voting FOMC member) proposal to move the ZIRP unemployment target from 6.5% to 5.5% today.
While there’s been some fierce selling in extended equities over the past two weeks, so far, there is zero indication of any mass exodus out of stocks, despite issues in Italy, Cyprus, and recent economic activity. Yesterday’s 2345 declining issues on the NYSE may have been a shot across the bow, and the number of declining issues has been increasing over the past two weeks. This is another de-risking indicator to watch over the next few weeks. If it isn’t answered by resurgence in buying pressure, then we may be looking at the typical spring correction right around the corner.
Tomorrow’s jobs data holds a lot of weight for investor; however, the private payroll employment number yesterday wasn’t encouraging. Even if the number is better than expected, I would think the reaction would be muted due to recent de-risking and an uncertain earnings season ahead.
