Chink In The Market’s Armor?

According to Wikipedia, the idiom "chink in one's armor" refers to an area of vulnerability. It has traditionally been used to refer to a weak spot in a figurative suit of armor. Since the beginning of 2013, the market has been seen as invulnerable.  Despite issues in the Eurozone, rising turmoil in the Mideast, riots and political clashes, rising oil prices and weak economic data – these issues bounced off the markets will little effect.  The markets craved "bad news" as it provided insurance that the Federal Reserve would continue its "liquidity drip."  By the end of last year, as the markets approached a 30% annualized return, I analyzed what 2014 might bring:

"I calculated the annual returns (capital appreciation only) using monthly data for the S&P 500.  I then showed just the first year in which a 30% or greater increase in the S&P 500 occurred and the subsequent years following that 30% gain."

Here are the statistics:

 

 – Number of years the market gained 30% or more:  10

 – Average return of 10 markets:  36%

 – Average return following a 30% year:  6.12%"

That analysis corresponds my discussion yesterday about the average return of the market during economic expansions with the Federal Reserve tightening monetary policy.

"If the current pace of reductions continues it is reasonable to assume that the Fed will terminate the current QE program by the October meeting.  If we assume the current correlation remains intact, it projects an advance of the S&P 500 to roughly 2000 by the end of the year.  This would imply an 8% advance for the market for the entirety of 2014.

Such an advance would correspond with an economy that is modestly expanding at a time where the Federal Reserve has begun tightening monetary policy. (Yes, Virginia, "tapering" is "tightening.)"

Of course, that does NOT mean that such an advance will be in a straight line.  With reduced levels of support from the Federal Reserve, the liquidity available to run the "carry trade" becomes an issue for the momentum driven sectors of the market.  The chart below shows the number of stocks on bullish buy signals.

While the broader market has risen sharply over the last year, there has been deterioration in the number of stocks on buy signals.  Historically, such an event has been coincident with the onset of market declines in the intermediate term.  However, due to the excessive injections of liquidity from the Fed, the markets marched upward despite less participation from its consitutents. 

Another indicator worth watching is the number of net new highs in the market.

This indicator has also been on the decline which, like the bullish percent indicator, has normally been consistent with short to intermediate term market corrections.

A "canary in the coal mine" is the recent gross underperformance by the "momentum stocks" over the last year.  Biotech, Netflix (NFLX), Linked-In (LNKD), Price Line (PCLN) and others all share a common attribute – very low outstanding share floats.  These stocks are excellent candidates for high frequency trading programs that can capitalize on "low float stocks" to push prices significantly higher.  That capability, combined with massive amounts of liquidity via the Fed, have pushed these stocks into the stratosphere.  However, as shown in the chart below, these issues are now grossly underperforming the broader market as valuations levels reach extremes while liquidity is slowly being drained from the financial markets. 

My money manager friend from California recently pointed out that:

"Many of these type of stocks are down 40% (e.g., 3-D printers, Twitter).  Others are down 15% (e.g., Biogen, Amazon). It's the absolutely classic first sign of the rollover."

I agree with that statement.  However, this does not mean that the market is about to come unhinged and plunge into the abyss.  However, it is worth taking note that previous "bullet proof" areas of the market are now beginning to take hits.  One area in particular, as noted above, is the biotechnology space.

I have noted in the chart above that downturns in the biotechnology sector have acted as a precursor to broad market corrections.  Currently, the correction in the biotechnology sector has accelerated against the broader market. 

Druing the last five years, it really has not mattered much where you invested your money.  The great thing about highly correlated markets, as shown in the next chart, is that everyone is a "freak'in genious" when the tide is rising.

The dark side to highly correlated markets, when the eventual correction does come, it leaves investors with no place to hide. 

It is important to note in the first chart above, that some of the biggest negative annual returns eventually followed 30% up years.  The current levels of margin debt, bullish sentiment, and institutional activity are indicative of an extremely optimistic view of the market.  What is important to remember is that margin debt "fuels" major market reversions as "margin calls" lead to increased selling pressure to meet required settlements.  Unfortunately, since margin debt is a function of portfolio collateral, when the collateral is reduced it requires more forced selling to meet margin requirements.  If the market declines further, the problem becomes quickly exacerbated.  This is one of the main reasons why the market reversions in 2001, and 2008, were so steep.  The danger of high levels of margin debt, as we have currently, is that the right catalyst could ignite a selling panic.

It is likely that the markets will experience a correction at some point in the near future.  What the data doesn't tell us is whether it will be a "buy the dip" opportunity or something much more significant.   However, given the length of current economic expansion and the extension of the markets above their long term moving averages, the Fed extraction of liquidity potentially increases the risk of a more significant correction than just a dip. 

Whether the current signs of deterioration is just a temporary rotation of "money chasing performance," or a warning sign of something more significant to come, is just too soon to tell.  Regardless, it is important to understand that it is always just a function of "when" a mean reverting event will occur.  Unfortunately for many investors who fail to understand the "risk" they have undertaken within their portfolios, when that time comes it will matter "a lot."