Stealth Bear Markets in U.S. Stocks Are Hiding in Bushes
Comment of the Day

October 09 2014

Commentary by David Fuller

Stealth Bear Markets in U.S. Stocks Are Hiding in Bushes

Here is the opening of this topical report from Bloomberg:

While the Standard & Poor’s 500 Index is still less than 4 percent below its September record, other gauges of U.S. stocks are revealing where risk has been taken off the most in front of an eventual “normalization” of monetary policy.

Most conspicuous are the 88 energy companies represented in the SPDR S&P Oil & Gas Exploration & Production ETF (XOP), a $1.1 billion fund. The ETF managed to rebound yesterday after falling 24 percent from its June record, though today it’s reversing those gains and setting a new 13-month low. Crude oil is down 22 percent from its high in September 2013 as the rallying U.S. currency lowers prices of dollar-denominated commodities.

While lower oil prices are good for many parts of the economy, keep in mind that crude and the S&P 500 are usually positively correlated, meaning they tend to move in the same direction. The correlation diminished in recent years, and even went negative for a short time in late July and early August. The last time it went negative for any significant period was around the bankruptcy of Lehman Brothers Holdings Inc. in 2008.

David Fuller's view

Churning price action, as we are now seeing on Wall Street, is an important technical signal.  However, the implications depend entirely on where it is occurring in the market cycle.

Churning after a bear market indicates that demand is returning, to match and eventually overwhelm remaining selling pressure.  The somewhat schizophrenic large daily moves that we are now seeing for US stock market indices indicate disagreement.  However, they are occurring following one of the more persistent and orderly demand dominated moves to the upside, as you can see on this weekly chart of the iShares Russell Microcap Index Fund

From late November 2012 until January 2014, the Russell Microcap Index mentioned in the article above, moved higher in a clear, orderly staircase step sequence uptrend, characterised by higher highs and higher lows.  Bulls were clearly in charge.  This began to change in January as the reactions became bigger, indicating that selling pressure was increasing relative to demand.  The pattern of lower highs and lower lows now indicates that supply in the form of selling pressure now has the upper hand.  The lagging 200-day (40-week) moving average is rolling over and turning down.  The Russell 2000 Index, which I have often posted, looks similarly toppy.  These are leading indicators and they will get bigger downside moves than big capitalisation indices such as the S&P 500 Index.    

The biggest risk for Wall Street, in my opinion, is not the corporate outlook and valuations; nor is it the bad economic governance from the Obama administration, from high corporate taxes to outsized fines for the banks, which deter lending; it is not even global concerns from the war against ‘Islamic State’ to sanctions against Putin, or the spread of Ebola, all of which drain capital.  No, the biggest current risk on Wall Street is leverage, also called margin debt.  You can see four very important graphs on leverage in my Markets Now PowerPoint presentation which I gave on Monday and also posted for subscribers on this site the following day.  You may be familiar with most of the material but do not miss slides 5 through 8, produced by Doug Short.  There is also an Audio covering this presentation which was posted on Tuesday.

The amount of leverage that could be unwound in a selloff would produce a significant correction, and even cyclical bear markets of over 20% for some US indices.  This would also drag many other stock markets lower, given Wall Street’s influence.  China would probably be least affected because the mainland’s bull market has barely started. 

I have previously suggested removing most leverage from your portfolios.  I would also be wary of speculative, high valued shares in this environment.  If you have attractively valued, big cap Autonomy type shares in your portfolios with attractive yields, you could ride out a correction and gradually add to your positions on further weakness, as Warren Buffett is doing.  However, if you wish to reduce your near-term risk, I would do so quickly, and not after a much sharper reaction when prices will be lower and sentiment considerably worse.     

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