Inside The Stock Market ...trends, cross-currents, and outlook

We have a hard time accepting that the excesses associated with an eleven-year bull market and expansion can be fully expunged in 27 trading days, no matter how ugly those days were… keep some powder dry!

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NASDAQ was the superstar of the bull market yet, ironically, it was a NASDAQ breadth measure that periodically signaled that all was not well beneath the market’s surface.

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We were fooled on Small Caps, and it’s been a “multi-factor” catastrophe.

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A composite measure of Mid Caps and Small Caps are at bottom-decile valuations relative to their 26-year histories. From a shorter-term viewpoint, though, we find it scary that valuations are so low just a single month into the recession.

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For those who must remain fully invested, an interesting (if not sickening) feature of the bear market is that those who entered it loaded with the most expensive and “trendiest” stocks and sectors have lost the least.

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In recent weeks, we’ve seen the “sell-side” investment community get about as cautious as it ever gets, recommending investors to “trim risky holdings on ‘up’ days” and “stay diversified.” However, these cheerleaders’ idea of diversification is usually to hold more equities in different sizes and styles.

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With the enormous popularity of ETFs, we’ve wondered if the high level of passive fund ownership could lead to stock price deviation from company fundamentals, and thus create greater price volatility.

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With an economic calamity and the Easter season upon us, we thought this would be a great time to resurrect our “Why We Normalize Earnings” vignette. Long time readers will recognize this as a staple from Green Books’ past.

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If it can recover from its February setbacks, the bull market will turn 11-years-old some time in March, and our Golden Retriever will turn 13 at the end of the month.

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With the wavering state of consumer and business confidence, even a modest stock market correction of 8-10% might deliver the fatal blow to confidence—and therefore to the U.S. economic expansion.

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There have been long-time divergences between blue chips and other market segments signaling that all is not “in gear” beneath the surface—but this cautionary activity never foretells the “timing.” Recently, Small Caps, the Value Line Arithmetic Composite, and Dow Transports staged pathetic bounces off the January 31st “Coronavirus 1.0” low, while the blue chips had strong momentum into mid-February. Normally, such divergences typically last for at least 3-4 months before they become meaningful.

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The massive performance dispersion of the past two years makes it difficult (if not hazardous) to draw a simple conclusion about U.S. stock market valuations. But it’s safe to say that cap-weighted indexes like the S&P 500 and S&P Industrial Index remained significantly overvalued at the low point of the February correction.

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The underperformance of Mid and Small Caps in the last few years has taken valuations from top-decile readings (and, indeed, a few all-time records) just 25 months ago, down to the middle—and even lower reaches—of their 30-year valuation boundaries.

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We can’t count the number of times in the last week we’ve heard analysts worry about “what the Fed might know that we don’t.” In the words of John McEnroe, “You cannot be serious!”

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If the U.S. economy falls into recession in the months ahead, it might be the only one in history that will be remembered as having been triggered by a “black swan.”

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There’s no question that it’s been a rough couple of years for stock market technicians. We noted earlier that if February 19th stands as the final high of the bull market, it would be only the third time in the last 100 years that the NYSE Daily Advance/Decline Line failed to provide at least a few months’ advance notice of the oncoming bear.

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The past 26 months have been wild ones for equity investors, but one could have essentially matched the S&P 500’s healthy return of +18.1% with a portfolio that was evenly split between the “fear” assets of Treasury bonds and gold. REITs have been solid, too, but EAFE and the Russell 2000 are now both total return losers since the beginning of 2018.

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In difficult market periods, Steve Leuthold liked to distinguish between conventionally oversold markets and those that had become “Jesus Christ oversold.” Recent action clearly qualifies as the latter. There are many ways to define a “dangerously” oversold condition, but the one that always raises our antenna is now flashing extreme selling pressure that might take longer than usual to mitigate.

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A dramatic shift of country weights within EM indexes has become an inadvertent challenge for a country rotation strategy. Due to this, we tested the integration of a momentum-based sector rotation model to attain exposure to the top-rated sectors to represent the markets of the largest country components instead of seeking to obtain “whole market” exposure.

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After last year’s spectacularly successful pivot following the December 2018 plunge, the thinking is that future rate hikes are the bull market’s only threat. Perhaps that will be the case; the belief is certainly well-supported by postwar U.S. economic history, but it also reveals a shocking lapse in short-term memory.

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