A Quick Overview

Below we briefly review updates of two charts we have employed in our recent market updates. The first one is a quick glance at several major indexes: the NDX, the SPX, the Russell 2000 and the DJIA. There have been multiple divergences between these indexes at their recent peaks, but there is also a divergence visible now that a rebound has begun – which is a direct result of the recent underperformance of momentum stocks. Note that we have taken this chart snapshot during the trading day, so it doesn't incorporate Wednesday's close yet.

The market has begun to bounce from a natural support level: lateral support in the NDX (as well as the Nasdaq Composite and the RUT) that has served as a support and resistance level on several previous occasions.

As you will see further below, although momentum and growth names are outperforming 'safe' stocks in Wednesday's trading, the trend toward safety is not undermined yet by this short term counter-trend move. There have been several short term pullbacks in the XLU-QQQ ratio since this new trend emerged in November, but the trend has continued all the same. On Tuesday, the ratio actually reached a new high for the move and is probably overdue for a pullback.

The Rydex sentiment measures we are keeping an eye on show practically no change since our last update. The only measure that is not firmly in cloud-cuckoo land just yet are total assets in bull and sector funds. However, relative to assets in money market funds and bear funds, they are near the peak levels recorded in early 2000. Bear fund assets and money market fund assets are at 17 year lows.

In short, while bulls appear not as strongly convinced yet as they were at previous major peaks, bears seem thoroughly dejected at the moment. Market participants who are merely cautious and are keeping some powder dry in the form of cash have become a distinct minority. So there is very little betting on the market's downside potential, and cash is widely regarded as trash. Regardless of the market's near term moves, these continue to be major warning signs. The Rydex fund family only represents a tiny slice of overall market activity, but we have found time and again that it reflects overall sentiment and positioning quite accurately. It definitely serves as a useful microcosm of general market sentiment.

Since a similar message is conveyed by record high margin debt, extremely low junk bond yields and a near record low mutual fund cash-to-assets ratio, it is clear that very few market participants believe that the market could suffer a significant decline. This is by itself of course no reason to expect the market to decline, but it does indicate that once a downtrend begins, it has the potential to become quite pronounced.

An overview over four important indexes: NDX, SPX, RUT and DJIA – click to enlarge.

In light of the fact that the bounce in SPX and DJIA has begun from a much higher level relative to the Nasdaq and small cap stocks, it is almost certain that if the former two indexes reach new highs in the current up move, yet another negative divergence will be created.

Another thing to watch out for is the nature of the rebound: the questions is whether it will display strong momentum, or whether its momentum will soon fade and waves begin to overlap. In the latter case, one would have to conclude that the larger trend has most likely turned down. It also remains to be seen whether the current rebound fails at a lower level (perhaps not in all indexes, but merely those that have recently underperformed). That would also be characteristic of a turn in the medium to long term trend.

Keep in mind that in light of recent money supply growth rates, weak, but not  too weak (i.e. not yet recessionary) economic data and valuations that are very high but have been even higher on a number of historical occasions, the market appears 'safe' to most observers and is therefore widely expected to move higher. Any clear sign that a medium term trend change is underway would be all the more significant in such an environment of complacency.

The XLU-QQQ ratio as a proxy for the preferences of market participants. A rise in the ratio indicates 'safety' is preferred to 'growth' and vice versa. Note that a healthy rally is usually accompanied by a decline in this ratio. The recent uptrend in the ratio therefore represents a warning sign.

Market Sentiment

We have been quite surprised by the fact that the recent sell-off in the most-loved momentum stocks (with biotech stocks e.g. falling about 21% from peak to trough, which is quite a sizable move) has essentially failed to shake the confidence of market participants to any significant degree.

Apart from the data in the charts on Rydex fund assets below, this is also evident in the NAAIM survey of active investment managers.

The Decisionpoint Rydex ratio chart. The ratio of bull + sector asset to bear + MM fund assets stands at a level that has thus far only been encountered in early 2000. Bear and MM fund assets are at 17 year lows – click to enlarge. 

A further comparison can be made in the form of a pure bull vs. bear assets ratio (leaving money market funds aside). Recently Rydex bull assets have soared, while bear fund assets have continued to crumble – sending the pure bull/bear fund assets ratio to a record high in late March:

Recently the pure Rydex bull/bear assets ratio stormed to a record high – click to enlarge.

Here is a long term chart of the average percentage of fund manager exposure according to the NAAIM survey:

The NAAIM survey: average exposure to the market reported by participating active fund managers – click to enlarge.

A brief explanation of the NAAIM survey: a range of responses regarding fund exposure is possible. These can be between: 200%  Leveraged Short, 100%  Fully Short , 0%  Cash or Hedged to Market Neutral, 100%   Fully Invested, and 200%  Leveraged Long.

Several things are noteworthy about the most recent data: first of all, similar peaks in exposure have only been observed in late 2006/early 2007 and early 2013.  Secondly, usually divergences between reported exposures and the SPX tend to emerge near market tops. These divergences don't 'guarantee' a market top, but their occurrence is in keeping with what we can traditionally observe in other positioning measures as well.

Sentimentrader also offers a 'survey intensity' chart, which measures the standard deviation of the survey responses. In theory, the less variance there is between the exposures of individual managers, the more meaningful the average exposure signal becomes.

NAAIM survey: exposure and 'survey intensity', i.e. the exposure variance between individual managers. The higher the intensity measure, the more meaningful the exposure signal becomes – click to enlarge.

Summary:

The market's recent correction may inter alia have been triggered by the mid April US tax payment date, but the trend toward 'safety' has begun a lot earlier already. In view of the many divergences that have been in evidence this year and the virtually unbroken bullish sentiment in the face of the recent swoon in  momentum stocks, one must keep a close eye on the current rebound to see if it shows any of the characteristic signs of a failing rally. These can consist of a peak at a lower level amid further divergences, or a rebound that shows signs of declining momentum and develops overlapping waves.

Keep also in mind that the 'presidential cycle' model calls for market weakness between April and October this year. So far this year, the market has conformed quite closely to the model (by weakening in January and subsequently rallying to a new peak).