A Harrowing Friday – Momentum Stocks Continue to Break Down

The release of Friday’s payrolls report was the worst of all worlds for the US stock market. This typically happens in bear markets: suddenly fundamental data that wouldn’t have bothered anyone a few months ago are seen as a huge problem. Why was it seen as problematic?

The report somehow managed to be weak and strong at the same time – it showed weakness in payrolls growth, but the entirely artificial U3 unemployment rate, which is distorted by the fact that a huge number of unemployed are no longer counted as unemployed, but rather as simply having “left the labor force”, fell below 5% at the same time.

Photo credit: Mike Kemp / Getty Images

This fact should keep the labor market-focused Keynesian leadership of the Fed (primarily Ms. Yellen herself) from moving very swiftly toward a loosening stance – although everybody knows this is what will eventually happen anyway. Does it actually matter? Not in reality, but it certainly matters to an already frayed market psychology.

If there is one chart that describes best that the US stock market has a really big problem now, it is probably this one:

The ratio of the Nasdaq 100 Index to the S&P 500 Index. The Nasdaq, which is primarily driven by big cap tech stocks was the one leading sector that still managed to hold things together while market internals deteriorated throughout 2015. Now its relative strength is beginning to break down as well.

As we have pointed out previously, the same thing has of course happened quite some time ago to other sectors that have been leading the bull market from the 2009 low. Here is a longer term chart showing two of them – small caps and transportation stocks – relative to the S&P 500:

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The RUT peaked against the SPX in early 2014, the Transportation Average in late 2014.

On Friday traders were rudely reminded of the fact that overvalued momentum stocks can actually go down as well as up – and they can do so quite violently. In the “social media” sub-bubble, companies are competing for people’s time. Since the day only has 24 hours, there are just so many things people can focus on – and it seems obvious that some of the companies competing for people’s attention and time will have to lose out in this contest, or will find that the pie they are competing for does actually not provide unlimited growth opportunities for all contestants. Shareholders in LNKD (Linked-In) received a harshly worded memo on Friday, so to speak:

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LNKD lost 43% or $11 billion of its market cap on Friday.

Numerous momentum stocks that are vastly over-represented in nearly every hedge fund and mutual fund portfolio (including the one run by that famous hedge fund in the Swiss Alps, the SNB) have broken important uptrend lines on a daily basis and in some cases on a weekly basis as well. Here are three prominent examples:

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AMZN, TSLA and NFLX – three favorite momentum stocks have broken their uptrends rather decisively.

We could have added many more stocks to this list of course – for instance, the biotech sub-bubble has been deflating rather quickly as well in recent months (it is under pressure since last summer in fact), but the above should suffice to get the point across: the final piece of the longer term puzzle has fallen into place, as it always does at these junctures.

The most egregiously overvalued “story stocks” always tend to have enormous blow-off moves at the end of an advance, while concurrently more and more market sectors are already entering bearish trends. They are thus always the very last stocks to peak. Once they do top out and begin to turn down decisively, it suddenly becomes clear to everyone that the market regime has turned from a bullish to a bearish one.

At the eventual bottom, something similar will happen, only vice versa: these stocks will very likely make a higher low while the rest of the market falls to a new low – this always seems to happen as well. But that is a discussion for another day.

Shades of 2000 Revisited

We already suspected in mid 2013 (worrying about the market far too early as it has turned out in hindsight) that there were parallels to what happened in the late 1990s bull market, specifically near its end in the year 2000.

However, in the meantime, even more such parallels have become noticeable. We hasten to add that today’s fundamental backdrop is very different in many respects, but there are also many noteworthy similarities (the most glaring one consists of extremely low commodity prices and rolling crisis conditions in emerging markets and their currencies). Here is a paraphrase of what we wrote in reply to a friend who wondered in what ways exactly we would describe the environment as similar:

In 2000 tech stocks went to the moon and value stocks were greatly depressed – we still remember the Tiger fund giving up in disgust a few weeks before its bets would actually have begun to work out. Of course there is no guarantee such parallels will continue, but they probably will for a while.

We have kept close watch on the gold sector and chronicled what has been happening there in these pages in recent months. We have just seen a strange deja vu there: the Rand implodes, and gold in rand streaks to a new all time high, taking the previously extremely depressed South African gold stocks up with it. Shortly thereafter, gold in USD terms begins to rise – which is what happened in 2000/2001 as well.

At the same time, we have seen the tech sector vastly outperforming in 2015, on the back of fewer and fewer big cap stocks – which is also very similar to what happened in 2000. Before the tech mania peaked in 2000, junk bond yields had been rising for well over a year already – just as has happened recently.

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Junk bond yields vs. stocks in the late 1990s – another strong similarity to what has happened recently

But wasn’t the mania of the late 1990s very different in terms of public enthusiasm and retail participation? It certainly was – here is how we would assess “then vs. now” with respect to this:

The late 1990s run-up was a mania that had great similarities to the 1920s bubble. Since then, the public has experienced two bear markets in just 15 years that have been among the four worst in history. So the public enthusiasm that prevailed in the late 1990s no longer exists – rather, as Bob Prechter has put it, we have experienced a “bull market with depressionary undertones“.

The year 2000 seems to have established the biggest extremes ever valuation-wise, but not in terms of the median stock. In terms of the median stock’s P/E ratio (i.e., leaving aside the skew of index valuations based on market cap weightings), as well as in terms of price/sales, the US stock market has never been more overvalued than in 2015.

One also has to consider that in spite of the apparent lack of public enthusiasm, people are just as, or even more exposed to the stock market today as they were then. According to Ned Davis, as of mid 2015 US household exposure to the stock market was at its third-highest level since 1952. It was only slightly higher in 2000 and 2007.

Below are updates of three long term positioning/exposure charts we have posted several times in the past: in terms of margin debt, the mutual fund cash-to-assets ratio and the ratio of retail money market fund assets to the market capitalization of the S&P 500 Index, the public’s stock market exposure – both directly and indirectly – has never been greater than it was last year:

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NYSE margin debt has risen to a record high and has begun to decline from there in recent months

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The mutual fund cash vs. assets currently stands at a record low of 3.2% – it stood at 4.4% at the peak of the tech bubble in 2000.

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Retail money market fund assets relative to the market capitalization of the S&P 500 have never been lower than in the period 2012-2016

As you can see from the above, these long term positioning and sentiment indicators continue to indicate that the stock market harbors enormous risk and that its downside potential in the long term is huge. This will remain true even if the current bout of weakness is reversed and the market rallies one more time.

Short Term Outlook

In the short term the market is becoming quite oversold. Based on current shorter term positioning indicators and the history of past bear markets that have started out with an especially weak January performance – which we have recently discussed (see The Stock Market Suffers the Worst Start to the Year Ever for details) one would expect that a rebound will soon begin, after perhaps after a few more days of weakness. The market should then establish a lower high sometime in the March-May time frame.

This is currently suggested by high and rising equity put-call ratios and large small speculator net short positions in stock index futures. Both may still have room to rise even further in the short term, but they are closing in on levels that have marked short to medium term lows in the past:

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The equity put-call volume ratio: at 0.92 it is already quite high historically, but there is still room for a further short term spike

As Jason Goepfert has suggested in a recent interview at King World News, futures positioning also seems to suggest that the bearishness of traders has become a bit too pronounced in the short term:

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The small speculator net short position in stock index futures has grown to quite extreme levels recently

However, both the market’s poor internals and the still very low VIX indicate to us that caution remains warranted over coming days:

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The VIX still remains too low…

A Major Caveat: Elevated Crash Risk

Here are a few caveats regarding the short term outlook: after China reported over the weekend that there was another outflow of nearly $100 billion from its foreign exchange reserves in January, markets are understandably rattled. Here is a chart from the WSJ illustrating the situation:

China’s foireign exchange reserves continue to decline rapidly, which suggests that a further devaluation of the yuan is ever more likely.

In a recent letter to Eclectica investors, famous hedge fund manager Hugh Hendry made the following remark in this context – he thinks China will refrain from devaluing its currency further:

“China would quite rightly be considered a pariah and its policy makers must surely expect a huge increase in trade tariffs and competitive devaluations from other countries. Everyone would lose.”

We are astonished what a crucial mistake in thinking Hendry is falling prey to here. For one thing, he seems to assume that China’s central planners have these events under control (and from his conversion to a bull not very far from the peak of the bull market he seems to think the same of other central planners – see “Hugh Hendry and the Blue Pill” for details on this).

Well, they don’t. There is a big difference between “having enormous influence on the markets and the economy” and “having control over them”. No-one controls the laws of economics or truly controls the markets. Hasn’t the downturn in China’s stock market just demonstrated this principle?

Secondly, he also seems to assume that China’s leaders are perfectly rational. One simply cannot assume that they are – in fact, we are certain that they are not. Very similar arguments were made just before World War I – many people looked at global trade (which was flowering at the time) and the economic interdependence it had created and concluded that “there can be no war, because everybody would lose”. They were right about one thing: Everybody did lose. But there was a war anyway, because human beings do not always act rationally.

Moreover, extremes in positioning and sentiment data have become far less reliable as contrary indicators in recent years – this quite likely due to the fact that a lot more automated trading based on predetermined rules takes place these days.

The combination of huge open interest in options relative to share trading volume and the prevalence of black box trading systems and HFT are bound to create far greater volatility – especially now that the period of “stealth deterioration” in market internals has been replaced by a more obvious, general deterioration in technical conditions. In other words, crash risk remains elevated.

Conclusion

Our “standard expectation” would be that the market suffers a little more near term weakness and then rebounds to a lower high in the March to May time frame. However, nowadays one can no longer blithely rely on “oversold” signals to necessarily stop very persistent trends. We have seen this time and again in currencies and commodities in recent years.

Moreover, all the long term indicators we follow continue to indicate that market risk remains extremely high. In many ways today’s situation is reminiscent of the previous bubble peak in the year 2000. We would say that the major difference between then and now in terms of investor behavior is that the late 1990s bubble was mainly driven by retail investors, whereas Ben Bernanke’s echo bubble was mainly driven by professional investors.

Since the broad true US money supply TMS-2 has expanded by 119% since 2008 and by precisely 300% since 2000, we need not discuss whether or not it is a bubble – it most definitely is one. The only questions are whether it is actually truly over (like the proverbial cat, it may still have another life left), and if so, how big the denouement will become and how precisely it will play out.

Charts by: StockCharts, SentimenTrader, St. Louis Federal Reserve Research, WSJ