No Trend Uniformity

As John Hussman points out in his most recent weekly missive, the stock market currently reflects all the characteristics observed near previous major market peaks. Apart from the more obvious ones, such as overvaluation and lopsidedly bullish sentiment which have been with us for some time, the market’s internals continue to deteriorate. This makes the current situation especially dangerous. As Hussman notes:

“When extreme valuations and lopsided bullish sentiment are joined by deterioration in market internals, one faces an environment that couples compressed risk premiums with increasing risk aversion. Throughout history, severe market losses and crashes have nearly always been the result of an upward spike in previously compressed risk premiums.”

Photo credit: Alamy

The deterioration in market internals is e.g. evident in new high/new low ratios that are inconsistent with a market making new highs, and a growing divergence between prices and advance/decline statistics. Also, an ever smaller percentage of stocks remains above important moving averages. Below is a chart depicting several of the most widely followed market internals (high/low percent, advance/decline line, S&P 500 stocks above 200 day and 50 day EMA).

What this essentially tells us, is that capitalization-weighted indexes are held up by an ever smaller number of big cap stocks. A the time of writing, a strong short term rebound in the stock market is underway. However, the underlying problems with trend uniformity and internals depicted below remain in place.

A number of important market internals – click to enlarge.

A large proportion of the stocks holding up the cap-weighted indexes are technology stocks, which is actually anadditional warning sign. At the peaks of 1998 (ahead of the Russian/LTCM crisis), 2000 and 2007, a handful of “horsemen” from the technology universe were the very last stocks to make new highs – it seems to happen every time.

A major reason for the deterioration in internals is the economic weakness currently spreading in China, coupled with malinvestment on a grand scale in the commodities sector over previous years. This combination is putting pressure on commodity prices and the energy and materials sectors have entered bear markets as a result. These two sectors together currently represent 15% of the market capitalization of the S&P 500 Index. Transportation stocks have begun to sag as well and have been in a down trend since the end of last year (see “Transportation Sector in Trouble” for details on this).

Lately, the weakness has however spread further, as industrial stocks have begun to join the decline as well. In order to provide an overview, we have picked the six charts below, which show the weakest sectors and the strongest sector (technology) compared to the SPX.

XLE (an ETF that serves as a proxy for energy stocks), XLB (materials ETF) and the Dow Transportation Average. Energy was the first major sector to enter a bearish trend (gold and coal have been in bearish trends for longer, but they are tiny sectors) – click to enlarge.

XLI is an ETF of industrial stocks – this sector has begun to deteriorate as well now, although it still remains stronger than the first three sectors shown. The strength in big cap technology stocks has helped the S&P 500 to remain in a sideways trend so far, while the Nasdaq Composite is actually still not too far off an all time high – click to enlarge.

It should be noted to this that once materials and energy have declined a lot, their weight in capitalization-weighted indexes will decrease and they will exert less and less influence on the overall market’s trend. Cap-weighted indexes have a built-in bias – the bigger a company’s capitalization becomes, the more it will influence the index and vice versa. This is one of the reasons why the stock market’s performance rarely reflects the performance achieved by most individual investors and fund managers, which is often significantly worse.

Over the past three months equal-weighted indexes – which one can think of as reflecting a “well diversified portfolio” better than a cap-weighted index – are markedly underperforming their cap-weighted brethren. Below is a chart of the Guggenheim equal-weighted S&P 500 ETF (RSP) vs. the SPX illustrating the situation:

RSP has begun to underperform SPX by putting in lower highs and lower lows – click to enlarge.

A Major Recession Warning

As we have often pointed out, GDP is not exactly a very useful economic indicator. Not only does it include what is ultimately wasteful spending such as e.g. government spending, it also suggests that a trade surplus or deficit is a measure of economic well-being and most importantly, it simply excludes the vast bulk of the economy’s production structure.

Dr. Mark Skousen has developed an index based on the gross output data of industry, which the government has thankfully begun to publish at greater frequency and with a smaller lag time (once upon a time, these statistics were only published every two or three years and were usually out-of-date when they finally did come out). As Dr. Skousen reports, the most recent release of gross output data for Q1 2015 suggests that the rate of growth of business-to-business spending continues to decline sharply. This is normally a quite serious early recession warning. In fact, B-to-B spending is already declining in nominal terms, and only the application of the (highly questionable) “price deflator” leaves it above the waterline in real terms. Dr. Skousen writes:

“Gross Output, a broader measure of U. S. economic activity published by the Bureau of Economic Analysis, continued to slow into the 1st quarter of 2015, confirming tepid growth in the economy and a potential recession. According to today’s BEA release, real GO advanced at an annualized rate of only 0.7% to $31.0 trillion by the first quarter of 2015, compared to 5.2% in the 3rd quarter and 2.6% in the fourth quarter of 2014. The downward trend in the economy continues. In nominal terms, GO actually fell 1.1% but price deflation was so strong that GO increased in real terms.”

Dr. Skousen’s B2B Index of US business spending (red line) vs. consumer spending (blue line).

As you can see from the chart above, there has been a serious deterioration in business activity. It is important to keep in mind in this context that the widely reported assertion that “consumer spending is 70% of economic activity” is simply wrong. It may be 70% of GDP, but it represents at most 35 to 40% of all spending in the economy. Business spending is the far more important statistic. Dr. Skousen also provides a comparison chart that is making this abundantly clear:

The nominal value of US business spending vs. US consumer spending (gross). Business spending is about twice as large as consumer spending – and it is turning down rather noticeably.

This is to our mind the strongest recession warning that has appeared in recent weeks and months. Other US economic data continue to show a tepid economy, but not one that is in imminent danger of falling into recession. The gross output data are however quite concerning in this respect.

Money Supply Growth

What makes this especially interesting is the fact that US money supply growth in terms of the broad money supply measure TMS-2 remains quite brisk at 8.4% annualized. We have long argued that the “recession threshold” is probably higher this time than it once used to be, as the economic recovery has been extremely weak so far. When not even major monetary pumping can create the illusion of strong growth anymore, it usually indicates that the economy’s pool of free capital, a.k.a. the pool of real funding, is in grave trouble.

The introduction of additional money into the economy can of course never produce genuine economic growth. In fact, it achieves the exact opposite. Central banks cannot magically produce real capital, but by incentivizing a misdirection of existing wealth into unprofitable ventures (the survival of which as a rule depends on continued loose monetary policy), they can help to create “activity” which is then measured by assorted aggregate economic statistics and masquerades as “growth”. In reality, a great deal of this activity simply consumes scarce capital.

The annualized growth rate of the broad money supply measure TMS-2 – since “QE3” has ended, it has oscillated between 7.4% to 8.7%, as commercial banks have taken the baton from the Fed and have expanded the creation of fiduciary media, primarily by granting commercial and business loans – click to enlarge.

While the annualized growth rate of TMS-2 has remained within the sideways channel established after the “taper”, there are some signs that money supply growth may be about to slow down more sharply. The narrow money gauge M1, which is closely aligned with TMS-1 (or money AMS, for “Austrian Money Supply”) has seen a notable reduction in its growth rate lately – and it often leads broader measures such as TMS-2:

The growth rate of narrow money M1 has already declined below the “shelf” and is now at 6.44% annualized – still high in a historical context, but probably already too low to keep all the bubble balls in the air – click to enlarge.

So far, money supply growth rates were the one thing that has kept us a bit cautious with respect to trying to pick a market top or forecasting an economic downturn, in spite of the fact that a great many market data (especially valuations, sentiment and positioning data) and economic data have suggested for quite some time that the ice has been getting a lot thinner.

It is not possible to determine in advance what threshold in money supply growth rates needs to be undercut to bring the bubble to a halt. In light of the recently spreading weakness in market internals it seems to us though that we are probably quite close to this threshold. Dr. Skousen’s B2B index meanwhile confirms that the economy is already much weaker than it appears on a superficial level.

Conclusion

Risk continues to increase. Given how oversold the commodity-related sectors are they seem actually ripe for a rebound, but such a rebound would likely only establish even more divergences at the next short term peak. Meanwhile it appears that the economy may actually tip over into recession sooner than expected.

Note in this context also a recent article by Lee Adler on initial unemployment claims. While these statistics have looked exceptionally strong lately, this is actually a phenomenon historically associated with bubble peaks. Businesses are beginning to “hoard” workers as Adler puts it, usually at precisely the wrong moment.

The recent decline in narrow money supply growth is another “early warning” type signal, although we wouldn’t want to put too much weight on this just yet. Should the growth rate of TMS-2 begin to weaken as well from here on out, it would definitely be time to go on “red alert”.

Charts by: StockCharts, Dr. Mark Skousen, St. Louis Federal Reserve Research