Barron's recently featured a talk with Doug Ramsey, Chief Investment Officer of Leuthold Group. After six years of gains, Doug believes the the bull market is "tracing out a top." "Valuations are high, yields are low, and areas like small caps, junk bonds and emerging markets have dipped in and out of bear territory - all worrisome signs for broad U.S. stock returns." I admire Doug's work (Doug was one of my sponsors of my CMT designation at the Market Technician's Association). So this week I will take Doug's comments in mind while we view a longer-term perspective on the markets. Here are a few indicators of market bullishness and their current state of technical affairs:
Small Cap vs. Large Cap Stocks
Small Cap strength and outperformance typically confirms the "risk-on" trade in equities. In the chart below, note how small caps underperformed the S&P 500 in 2014 (the brown line is a ratio of the Dow Jones Small Cap Index vs. the S&P 500). Small Caps recently bottomed out in October, and have since been recovering. Recently, however, small caps blazed against volatile general market indices, a potential sign of improvement in market internals.
As seen in the chart below, small caps have continued to outperform the S&P 500:
Dow Theory Confirmation (or lack thereof)
Dow Theory non-confirmation is another interesting, recent indication that a topping pattern in equities may be emerging. See this article in MarketWatch. Note that the Dow hit a new high in February, but the Transports lagged. This is resolved either with the laggard index (in this case the Transports) catching up with the leader Dow, or the laggard pulling the leader down. What's funky about this technical indicator is that it may be a 50/50 chance of either transports catching up or the Dow "catching down." For additional insight into the current view of Dow Theory, see this report by Matthew Kerkhoff.
Growth vs. Value
Growth has outperformed value as noted in the relationship between the Russell 2000 Growth Index and the Russell 2000 Value Index in the chart below (see the green boxes). Those timeframes tend to be positive for the S&P 500. Recently, this relationship has looked a bit toppy with RSI again breaking above 70, a point at which past outperformance has reversed toward a more "risk-off" trade (denoted by the red boxes).
Left unsaid in the above charts has been impressive market breadth in the major indices. For more on this, visit "A Breadth of Fresh Highs" from the Baseline Analytics Market Tour Blog.
To respect the longer-term view, I visited Doug short at Advisor Perspectives. Doug's current assessment and outlook, as published in his March 16, 2015 analysis of economic indicators (click here for Doug's detailed report) is that
"The overall picture of the US economy had been one of slow recovery from the Great Recession with a clearly documented contraction during the winter of2013-2014, as reflected in last year's GDP for Q1 of last year. In April we'll get our first peak at Q1 2015 GDP. Preliminary data suggests that we'll see renewed finger pointing at the weather. The Big Four average in recent months suggests that the economy remains near stall speed."
In my opinion, to harken back to Doug Ramsey's perspective, a stalled stock market is consistent with a "stalled speed" economy, economic fundamentals catch up to valuations (and the financial juice injected by the Fed through last fall).
A few economic indicators point to a potential inflection in the markets, based on past performance. Below is a chart of Initial Claims for Unemployment and the Wilshire 5000 Index. Note that initial claims have tended to find a bottom in the 250,000 to 300,000 level consistently since the mid-1970's. Also note that there is a fairly consistent penchant for troughs in initial claims to precede tops in the Wilshire 5000. The noteworthy exception can be seen in the "roaring 1990's" in the stock market, as the trough in initial claims in 1988 was not followed by any meaningful market setback. Even if economic growth opportunities today mirror in part the growth of the 1990's, visually the sharp ascent of the Wilshire 5000 is pronounced (as can be seen at the right of the chart in the orange line) and worthy of a bit of vertigo.
On a high level valuation perspective, the market has been tracking the growth in corporate profits rather steadily. As expected, corporate profit growth tends to do a fair job of leading the market, as can be seen by the peak in profits in 2007 leading the topping action in the S&P 500, and similarly in 2011. Note the timeframe of 2013 and later; there is a rather steady wide gap between the percentage change (from the prior year) in corporate profits vs. the percentage change in the S&P 500, the latter of which has settled toward the 15% level while the former is closer to single digits. Could this be suggestive of a slowing in the S&P 500 growth rate to a level more consistent with the slowing growth in profits?
Our next view is a monthly chart of the S&P 500. Although forecasting a market peak is a mix of technical analysis and black magic, it is interesting to note that a cyclical overlay, showing peaks and troughs over the last 20 years, reinforces the age of this bull market:
So should this be the peak year, where might the bottom be? One approach is to apply Fibonacci Retracement levels to the current bull market, starting with the lows of March, 2009. A "modest" 38.2% retracement in a secular bull market would put the S&P 500 at the 1600 area. Using our two year spread between peak and trough would suggest 2017 as a bottom. See below the monthly chart of the S&P 500 with a fibonacci retracement overlay:
In periods of rising economic growth, falling bond prices (rising rates) does not mean stocks need to decline too. In the chart below, I have circled (see red ovals) the periods in which bonds have dropped (the 30-year Treasury) but equities (S&P 500 shown by the green line) have climbed. Despite a variety of technical relationships we can identify to support (or deny) the direction of the stock market, the main factor to keep in mind, in my opinion, is the age of this bull as referenced above by Doug Ramsey.
So what's the strategy? Yes the bull is aging, but even flat to single-digit returns over the course of an upcoming two-year period, marred by a correction (perhaps when rates finally do climb) may not be all that bad. Beware that at some point the inevitable recession will surface, and the aforementioned correction may be the leading indicator to such an event. As a tactical approach to this market environment, long term investors should maintain a responsible blend of equities, bonds, cash and alternatives, commensurate with their risk profile.