Market internals deteriorated sharply last week, following an extended period of overvalued, overbought, overbullish conditions where interest-sensitive sectors have been under considerable pressure. At present, the line of least resistance appears downward. That will change. It may change quickly, and while we haven’t seen a material retreat in valuations, a firming of market internals even here might support a somewhat more constructive outlook. Still, investors should also recognize that the sequence of conditions we’ve observed – strenuous overvalued, overbought, overbullish conditions, followed by distinct weakness of interest-sensitive sectors (Treasury bonds, corporates, utilities), broadening internal dispersion and reversals in leadership (new highs/lows) and breadth (advances/declines) on both longer-term and high-frequency measures (e.g. another Hindenburg on Wednesday) – these are conditions that have historically preceded panics and crashes. They are indicative of a shift from risk-seeking to risk-aversion.
Make no mistake, last week’s decline was not because of a hawkish Federal Reserve, but in spite of a dovish one. On Wednesday, Ben Bernanke essentially promised that the Fed would continue to expand the size of a balance sheet that is already leveraged nearly 60-to-1 against its capital, regardless of market distortions. Though the Fed might possibly reduce the rate at which it expands that position, Bernanke indicated that the Fed will not stop adding to it until at least 2014 (stopping only on the basis of economic improvement that we view as implausible). Anyone who understands the relationship between short-term interest rates and the amount of monetary base per dollar of nominal GDP also understands that Bernanke has promised that short-term interest rates will be repressed as far as the eye can see. There was no talk of risks. Not a whisper about diminishing benefits. No – Bernanke came in full-metal dove. Perhaps shaken by the market reaction on Wednesday afternoon and Thursday, Bernanke evidently dispatched the Wall Street Journal’s Jon Hilsenrath to suggest that the markets were ignoring all those dovish signals from the Fed.
In short, the only thing that happened with Fed policy last week was that Bernanke reiterated a dovish stance. While QEternity will become QEventualTaper, the Bernanke Fed does not actually contemplate stopping until the unemployment rate comes down, even though that objective is almost entirely detached from Fed policy itself. Investors who believe that “QE makes stocks go up” – with no other condition required – just got a handwritten, perfumed note from Bernanke to keep buying.
The fact that we are instead seeing broad internal deterioration here is of some concern, because it smacks of something more afoot. It might be the increasing credit strains in China. It may be growing expectations for disappointing earnings preannouncements. It may be economic weakness that finally catches up to the general (though not uniform) deterioration that we’ve seen across leading measures of economic activity. My own litany of concerns is well-known (see Closing Arguments – Nothing Further, Your Honor). But whatever the reason, investors appear to be shifting from risk-seeking to risk-aversion.
Then again, it might be that investors simply overreacted to the Fed, and everything else is just fine. If that is the case, I would expect even our own views to become somewhat more constructive on an early firming of market internals. We don’t have a very wide window between here and the point where we would likely observe overbought and overbullish conditions, and valuations certainly haven’t eased much, so my inclination is that the best way for investors to take market risk in that event would be to use limited-risk instruments such as call options. We’ll take the evidence as it comes.
What concerns me most is that the present market environment is very reminiscent of other cycles in which deterioration of interest-sensitive securities, following overvalued, overbought, overbullish conditions, was then joined by broad deterioration in market internals. The chart below shows the points where the overvalued, overbought, overbullish syndrome I noted a few weeks ago in Not In Kansas Anymore was followed by a deterioration in utilities, corporate bonds, breadth, and leadership, relative to the prior quarter. There are five instances: 1929, 1987, 2000 and 2007 and today. The prior ones are associated with some of the worst market losses in history. Longer-term readers may recall my concern about this same sequence in 2007 (see the July 30, 2007 weekly comment Market Internals Go Negative). 1973 does not appear in this set because the 1973-74 plunge was not precededby a deep deterioration in interest-sensitive securities, though they did lose value later in that bear market. 1937 does not appear only because we’re using a particularly tight definition of overvalued, overbought, overbullish conditions. Suffice it to say that the historical record is not encouraging toward speculation here.
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