As we survey the financial markets and global economic backdrop, it appears that a change in the wind could be slowly taking place. Across the tides of global capital markets, a chillier wind may be starting to blow, ushering in what could soon be some sweeping changes in the major trends for primary capital markets. In China, the air of debt deleveraging seems to be taking root, with tightness in the money markets, bond market collapses, bond market closures, and inverted yield curves. In addition, there are also widespread rumors surrounding the viability of an assortment of wealth management products that have embedded duration mismatch problems baked into the cake.
Here at home in the USA, boom times remain in full swing with stock market averages busting out to new highs seemingly day-after-day. Yet, behind the bullish headlines, there seems to be developing a clear pattern of parabolic (terminal) excess within the technology space, a pattern familiar to those market watchers who recall 1999 and 2008.
Sure enough, for the most part, today’s current valuation metrics for technology stocks are nothing close to the fantasy price-to-eyeball ratios that seemed to capture the imagination of so many when the first internet boom developed in the late 1990s and peaked in March 2000. Yet, today’s market harkens back to a blend of the pre-tech wreck mania vertical blow off patterns and the famous Nifty 50 market of the early 1970s.
For thus far in 2017, a sizable portion (closing in on 50%) of the S&P 500 total gain lies in the domain of just a handful of large technology names. At the same time, these charts now display the unmistakable signs of ever increasing parabolic excess with overbought readings at present that suggest a close proximity to a potential downside reversal of size.
That downside reversal may have just commenced during the session of Friday, June 9, 2017, where NASDAQ swung more than 4% off the highs in just a few hours. For many, the biggest mistake possible could be overstaying this party too long and having to wake up one of these mornings and face the full wrath of the inexorable hangover. Seldom in recent years has the phrase ‘risk-control’ needed a more definitive under-score.
After all, while the party has not been of historic amplitude, the bull market underway in 2017 has been a champion in longevity with its true origins harkening back to the dark days of early March 2009. That puts the current bull market as number two on the all-time list of longest equity bull markets with the top ten longest bull markets invariably followed by what seem to be substantial bear market declines each and every time in the past. Of course, there is always the exception. Yet, while stocks look increasingly extended, on the other side of the spectrum, we see bonds and gold as viable alternatives and candidates for appreciation in what could soon be a very important global macro gear shift.
At the center of any primary trend change these days, one can always find the merry money printers at the global central banks where the over-riding emphasis is to present a still dovish monetary policy even while quietly sneaking up rates. Back in the 1970s, the famous market analyst Edson Gould often noted that early stage Fed tightening was tolerable for equity markets, but beyond a certain scope monetary tightening could suddenly become toxic and hence he arrived at the infamous “three steps and a stumble rule”. This did a good job for many years at identifying the point where monetary tightening by central banks went from benign to harmful.
The last two years, we have seen a kind of quiet, low-keyed, pseudo tightening from the Fed, which started from all-time lows in rates. Over that time, the pattern that has emerged shows rates periodically sneaking higher, amid a dialogue and guidance surrounding each announcement that has remained softly worded. Hence markets have continued to move up and party on, undeterred by the gradualist moves by the Fed. Yet, despite this gradualist, “data dependent”, barrage of dovish dialogue, financial markets may soon be hearing louder overtones of real financial tightening, this time in the form of quantitative tightening (Q/T) which could occur later this year as the Fed begins letting bonds roll off its bloated balance sheet. Once again, the Fed seems to be trying to manage expectations well in advance with a discussion of monthly caps, and a slow and steady pace to balance sheet reduction. The question that arises is whether markets will remain in a mood to tolerate soft tones, or whether they will start to look through the soothing language and begin to focus more on the final outcome.
Back in 2013, when the Fed made a small communications miscue and suggested the potential for real tightening, markets turned savagely on the Fed in the so-called “Taper Tantrum” where stocks, bonds, and commodities began falling sharply for several weeks. Today, with far, far more leverage at work in the system, the risks of any type of real tightening could trigger an even more dramatic and lasting market reversal with far-reaching implications for economic growth and overall financial stability. Never before in the past have the equity markets been able to erase dollar amounts in the trillions from the global economy as quickly as they can today. This heightened sensitivity to central bank policy is accentuated by the fact that markets currently trade at lofty valuations; valuations that in most cases, are pressing historic highs.
Among many valuation gauges that point to potential excess, the Shiller Cyclically Adjusted PE (CAPE) Ratio (above) resides this year at among the highest values of the last century, with the lone exception being the few months surrounding the height of the technology mania in early 2000. At the same time, S&P Price-to-Sales Ratios (also above) are near all-time highs, along with the Stock-to-Bond Ratio (below left), and the Buffet Market Capitalization to GDP Ratio (below right).
Other warning flags can be found in the realm of technical analysis where sentiment readings are among the most bullish values seen in a number of years. These suggest that there is room now for a contrary stance where excess positive sentiment tends to be an especially powerful indicator in the latter phases of an extended cycle. In our work, we also note that while overall breath is still reasonable when viewing composite advance-decline data, lately, there has been a marked drop-off in volume. Volume is the fuel and lifeblood for bull markets and volume tends to be highly coincidental and even leading a bit at key turns.
In the chart above, we show our S&P 500 proxy in the top clip and cumulative up to down volume in the lower clip. Over the last few weeks, as the S&P has moved to new all-time highs, the up-to-down volume ratio has been lagging and unable to make new higher highs. This is behavior that on the whole looks a lot like that seen in the middle of 2015 leading into the July highs and preceding the August China devaluation decline.
Above: Up-to-Down volume failed to make new highs at the double top peak in 2007-2008 and the breakdown below long term moving averages by volume in 2008 confirmed a directional shift into a bear market.
Above: Similar behavior was also seen at the big turn in the equity market in early 2000, just as the NASDAQ bubble began to crumble.
Above: The ARMS Index (inverted) for the broad market is now back to intermediate term overbought values and showing a bearish divergence with prices. This is a strong caution signal.
In the same vein, the ARMS Index, or TRIN, is a gauge that employs the combination of both advancing and declining issues in addition to up and down volume. A ratio of a ratio, the ARMS Index tells us how much selling pressure is taking place on the stocks that are going down, versus how much buying pressure is taking place on the stocks that are moving up. When there has been a long-standing absence of selling pressure in the equity market, ARMS moving averages tend to decline and become very low. That has been the case over the last few weeks, as ARMS Index moving averages have declined back to overbought levels.
In the chart above, we plot the ARMS Index for the broad stock market inversely so as to make the indicator easier to understand visually. Note that recent readings show the gauge back to the high end of the range, fully overbought, and showing a negative divergence against price. This is usually a pre-condition for an important market top. On the next page, we show the ARMS Index for both technology stocks and semiconductor stocks, where in both cases, recent readings have been showing overbought extremes along with bearish divergence.
Above: A basket of Large Cap Technology Stocks with Intermediate ARMS (inverted) is also extremely overbought. These types of readings tend to highlight medium term extremes so even if prices recover, there is a larger overtone to this type of bearish reading.
Above: Semiconductor stocks with Inverted ARMS, also extremely overbought. Note that this gauge is also diverging in bearish fashion as prices made new all-time highs.
Above: Semiconductor Stocks with Intermediate Advance-Line Ratio at record overbought values.
Above: The expanded list of FAANNG Stocks, Facebook, Apple, Amazon, Netflix, NVIDIA, and Google are also at record overbought readings and are diverging amid a near vertical run.
Finally, the last chart in this sequence shows our Intermediate Advance-Decline Ratio for a broad basket of semiconductor stocks, which over the last few days recorded the fourth most extreme overbought condition of the last 27 years. This was happening just as the index approached the March 2000 peak, the area of the old highs.
Above: NASDAQ 100 Index with rising channel and RSI. So far, the rising channel is intact but the recent break has wounded upside momentum. This is a serious warning that the larger uptrend is now exhausting.
Overall, we would look at the weight of the technical evidence and conclude that the sharp technology stock led decline feels like an early warning of a larger trend change getting underway. We want to be clear, that tops are often a process, and therefore, we would not be the least bit surprised to see both the NASDAQ Composite Index and the NASDAQ 100 (symbol: NDX) Index move back up and make new somewhat higher highs in the days just ahead. That type of behavior would form a potential double top which is a very common type of primary trend reversal pattern. The key to concluding a double top would be that following another round of new highs, the key tech names are then unable to hold those levels and, subsequently, prices begin to trail off and move down to new lower lows. A break down to fresh new lows would then be a significant sell signal and a warning that the long bull run of the last 9 years had finally peaked.
The implication at that juncture would be that a larger Elliott Wave downward corrective move would be getting underway that would retrace a portion of the entire preceding bull market advance and with that, likely usher in an end of the friendly “passive” investing environment of the last several years. Alternatively, in the short term, we would be watching the 5630 level on the NASDAQ 100 (NDX) and 6,100 on the NASDAQ Composite as key zones of support. Any move below the lower boundaries of those ranges on the key NASDAQ Indices, combined with a move below 2,417 on the S&P 500, would negate the potential for new highs and signal a full on intermediate correction or bear market getting underway.
Elsewhere, we are watching Gold and Gold Mining Stocks very closely, as these can often have a negative beta to the broad market. Last year, Gold Stocks rose more than 155% in just a little more than 6 months. Since then, they have experienced a major downward correction between August 12, 2016 and December 20, 2016, with that decline retracing approximately 66% of the initial six-month advance and leading to an extended sideways basing period that has been in effect from December of last year thru the present.
In our work, we see much to be optimistic about regarding the trend looking forward for both Gold and Gold Stocks. While the crowd has been anticipating that Trumponomics would be bullish for the US economy pushing growth to near 4% over time, the reality is that the US appears to be slowing down in significant fashion with leading gauges such as Commercial and Industrial Loan growth flashing early recession warnings. It is interesting to note that in the first year following two-term presidents leaving office, the economy has very often moved into recession. At the very least, with the Trump tax cut agenda experiencing a much longer than expected delay, the odds are high that growth will remain in the strata near 2% with a pause in Fed rate hikes following June.
Above: Salem Gold Mining Index with On Balance Volume gauge.
Any pause in the Fed rate hike cycle will hurt the US Dollar and help gold. In addition, slowing growth in Asia, and especially China, is once again weighing on raw materials prices. Crude Oil currently faces a substantial supply glut which is very likely to continue to depress energy prices for some time to come. In the case of mining companies, a falling Oil price is a big positive as one of the major costs for gold miners is energy expense to run haulage trucks and heavy equipment.
Above: the 20 Year Bond ETF, symbol: TLT. TLT appears to be emerging from a large multi-week base suggesting that interest rates could be heading still lower over the medium term.
If the Gold price soars above 00 an ounce, for many miners the current low growth rising inflation (quasi-stagflation environment) would be the best of all worlds. Add in a potential bear market in equities and Gold Miners could feed greedily at the trough. In the past, we have seen the Barron’s Gold Mining Index move up dramatically, in several cases, where equities moved into extended bear market declines. At the moment, we are watching the volume pattern in the gold mining stocks which appears to be in a large horizontal triangle pattern. In our view, the overall tone here looks potentially very bullish and any move back above .80 for more than a few days by the widely watched Gold Miners ETF (Symbol: GDX), would be exceptionally bullish. We are also bullish on long duration Bonds which appear to be coming out of a huge base and look ripe for a move higher, especially as foreign money looks at historically wide Treasury to Foreign yield spreads.
For more information on Salem Partners or their services, please go to www.salempartners.com.