How healthy are the markets

One of my favourite quote from the legendary investor Stanley Druckenmiller is the following one: “markets tops on liquidity and technicals…not on valuation”. I believe that by “technicals”, Stan is including all the breadth/quantitative/volume/price/chart indicators investors have at hand.

I have noticed that the best “compounders” like William O’Neil, Mark Minervini, Gil Morales, David Ryan use a heavy toolkit to establish what market regime we operate in.

 

As a reminder, if you had sold the market on valuation reasons in December 1996 when Alan Greenspan talked about irrational exuberance, you would have left 113% on the table as the SPX did not top before March 2000…

 

Not only do they screen for the best stocks, do the fundamental analysis, work on the technical entry levels and check constantly the leadership of the markets, but they also work on the breadth on a mechanical/regular basis to define the risk appetite. This make huge sense given that stock picking does not drive more than 20/30% of a stock price on average vs. 50% for the market and 20/30% for the sector. So, ignoring the 50% that makes up for one’s performance can be a very risky game even for market neutral fund. Hence, the use of a toolkit based on hard data enable investors to rely less on “opinions”, “emotions”, “sentiments” and more on numbers.

We all know the issue with valuation, they are vague as the PE could be seen on an absolute level,  relative to bond yield, to history, to 5ye EPS average or 10ye, the DCFs use tons of hypotheses, and same for FCF yield...and market can be “too expensive for longer than you can stay in business”. As a reminder, if you had sold the market on valuation reasons in December 1996 when Alan Greenspan talked about irrational exuberance, you would have left 113% on the table as the SPX did not top before March 2000…

On the other hand, hard data like A/D Line, new highs/new lows, progressing sectors, force indicators, moving averages, buckets…are pure facts/observations. If you are organized, it can take less than one hour during your weekend and a few minutes per day to work on the breadth and listen to what the market it telling us. All part of your daily gymnastics..

What do we see with our indicators?

Since early October, the breadth has narrowed despite the index moving higher. This means we rely on fewer names to lift indices.

 

 

%B Analysis

There is a good evidence of this deterioration by looking at the “buckets” evolution in the last three weeks. This indicator tells us how many stocks within the S&P1500 trade above the mid-point of the Bollinger band. A strong market is driven by a large number of stock being between the mid-point and the upper band. Obviously when too many stocks are at the top end of the band (higher green bars on the right) then it could become too “hot”. So, what you want is more green in percentage but no extreme on bar sizes.

This is %B Analysis as of end of last week. Still strong but deteriorating:

 

The % B analysis two weeks ago:

 

The %B analysis three weeks ago:

Hinderburg Omen

If we move to another indicator that is concerning, the Hinderburg Omen, one could as well have seen (and see) that some part of the market is under higher risk.

There is a lot of literature on this indicator and many ways to look at it. The rationale is that under "normal conditions" a substantial number of stocks may set either new annual highs or new annual lows, but not both at the same time. As a healthy market possesses a degree of uniformity, whether up or down, the simultaneous presence of many new highs and lows may signal trouble.

Under the definition of the database I use, four “Hindies” have appeared on the NYSE recently...this is another sign that we could be in a distribution/correction mode at the moment.

Distribution Days

The distribution days is another useful tool to use. A distribution day on its own does not mean much but what matters is when you count several in a short period. This has been a bigger concern for Europe than the US, taking a look at the SXXP (STOXX Index Europe 600), which has fired three distribution days in a very short period of time (and three more if you count from early October).

Also, see how the moving averages have crossed on the SXXP: the 50 days, 100d and now 200d. This is not the case for the major US indices at this stage. Clearly the European market is looking worse than the US ones…for a change!

SXPP performance:

 

The Canaries index which includes Apple, Facebook, Google, Netflix, Tesla, Amazon, Alibaba, Nvidia, Priceline is also looking weaker on Volume/Price Analysis (see the red on the chart). So one has to look closely at the index as when the leaders correct, the whole market may follow.

Canaries Index

But the analyses we discussed show that the risk of a market pull back is much higher than a few weeks back as the depth of the rally is thinner. This analysis shows that the vulnerability of the market has gone up since early October.

Currently, there is little indication that the bull market which started in Spring 2016 is about to derail: economic surprise indicators at best in years, cash level still high, psychology indicator (like AAII surveys) drop quickly as soon as the index lose 25bps, results in the US surprised on the upside, moving averages on the US index are well “stacked” (in order), cycle leaders still trending up...

But the analyses we discussed show that the risk of a market pull back is much higher than a few weeks back as the depth of the rally is thinner. This analysis shows that the vulnerability of the market has gone up since early October.

Such a deterioration in breadth indicator should push European and US investors to increase cash or reduce risk and lower their gross exposure. Some individual names are still doing really well even in leading sectors (Weibo, Square, Site One, IBP, MA, PayPal, RedHat, Coherent, Align, SalesForce, American Tower..) but there are less and less “clean patterns” and many names are extended from their “natural entry points”. At this stage the market looks toppish, tired and has a higher probability of “pausing” or decline.

Fred Batoua, Equity Strategy Specialist