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

While the past several months’ reversion in valuation measures has certainly wrung some of the risk out of the market, if the bear market reasserts itself and drives stocks to valuations seen at average cycle lows, downside risks are still substantial.

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High Beta has certainly lived up to its billing, during both the multi-month decline and the three-week rally off the February 11th correction low.

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Relative valuations of Staples and Utilities sectors already reflect a “flight to quality” effect. Investors looking to add some economic/stock market defense should focus on the cheaper Health Care groups.

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Based on comparative valuations alone, one could have made a case for investing in foreign stocks over domestic ones as early as 2010—when EAFE’s valuations sunk to an historical low, relative to the S&P 500. Today, that gap remains extreme.

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Industrial commodity prices and the latest ISM figures both point to a stabilization in the manufacturing sector following a two-year deceleration. Expectations for this year’s earnings have turned more optimistic as a result, but are the hopes warranted?

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If February 11th marks a lasting low for stocks, the 2015-16 decline will go down as one of the costliest in history not to have reached bear market status.

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The S&P 500 decline has yet to come close to a bear threshold, but it’s nonetheless been sufficient to drive the Very Long Term (VLT) Momentum algorithm into oversold territory for the first time since late 2009. In 16 of 21 prior cases, VLT Momentum’s initial oversold reading was a harbinger of a market that was soon to become even more oversold.

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Bear markets need a “hook”—some sort of misdirection that keeps the majority hoping. Our work suggests a primary bear market is underway, and we fear oil is this bear’s hook…but the problems run deeper than oil.

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As quantitative investors, the disciplines of the numbers trump stories—even our own. But we’re struck that the stories depicted by our Major Trend Index and other market tools over the past two years are entirely logical and sequential. Unfortunately these stories rhyme with those of past market cycles.

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At its January 20th closing low, the S&P 500’s peak-to-trough decline of –12.7% barely met our definition of a severe market correction (an S&P 500 loss of 12% to 18%). But the behavior of this particular index can be quite sinister during the final phase of a bull market—and during much of the ensuing bear.

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At the August and late January S&P 500 lows, both the Daily and Weekly NYSE New Lows figures exceeded 40% of Issues Traded —a degree of downside thrust rarely seen outside of bear markets.

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There’s an old trader’s adage which holds that “the most powerful sell signal is a failed buy signal.” Last fall we noted that European equities and Small Cap Value had triggered BUY signals on our Very Long Term (VLT) Momentum algorithm.

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If the current global bear market manages to shake investors’ blind faith in central bankers, this decline might actually accomplish something in the long term. But breaking that faith will take awhile.

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This month’s “Of Special Interest” allots eight pages to the (opposition) view that the correction is over, featuring charts we find the most threatening to our bearish stance. Based on its sudden popularity among the press and punditry, the indicator in this chart—highlighting the air-pocket in investor confidence—perhaps should have been part of that feature. Here’s why it wasn’t.

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By now it’s consensus that the Fed missed the ideal window for the first rate hike (if one ever existed) by at least a year and a half. We don’t disagree…

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In the context of a low growth/low inflation environment, with the Fed taking its time to guide rates upward, fixed income type of investments may pale by comparison to dividend paying stocks.

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The most compelling evidence that a bear market is underway may not be what’s been punished (Transports, Small Caps), but what hasn’t. We believe the final bull market highs of any composite or sector index were recorded on December 29th.

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Among the dozens of indexes we monitor, the year’s final all-time highs (S&P 500 Consumer Staples and S&P 500 Low Volatility Index on December 29th) can’t possibly provide any comfort to stock market bulls.

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We’ve long argued that this tightening cycle began in January 2014, the month of the first of seven tapering moves which occurred through October of that year. There’s both economic and market evidence to back up this claim.

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The Dow Jones Transports was the first U.S. index to top in this cycle (December 31, 2014), and it closed January 7, 2016 down 24.1% from that historic high. That development, in and of itself, sharply increases the odds that a new cyclical bear market is underway.

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