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Complacency in the equity market is nearing historic levels and it isn’t difficult to understand why. The S&P 500 has gone 371 trading days without a test of its 200-day moving average, the longest stretch in the past 50 years with the exception of the 385 day run in 1995-96. Over the past 17 months, every dip has been a good dip to buy, which has created a powerful positive feedback loop encouraging new investors to jump in after any small decline.
With the S&P 500 once again hitting a new all-time high this week, most investors are expecting more the same going forward. While this is certainly possible and it has been a mistake to underestimate the resiliency of U.S. equities over the past year, the character of the market has changed over the past few months and not for the better. The question for market participants is how much longer we can see weakness in key intermarket relationships without a real correction in the major averages.
Small Cap Weakness
In both March and April, the small-cap Russell 2000 declined while the S&P 500 advanced. This was the first time in history that we saw this divergent action and it has continued thus far in May. The Russell 2000 moved back below its 200-day moving average Wednesday while the S&P 500 hit a new all-time high on Tuesday (see chart below). This is a sign of weakening breadth as the average stock is not keeping pace with the larger, cap-weighted index. It also an indication that investors are moving down the risk curve, out of higher growth, smaller companies and into slower growth, larger companies.
Entering the year, most investors were expecting “rising rates” as that is what had occurred in 2013. From the 1st day in January, however, we have seen the exact opposite, with long duration yields showing a persistent decline this year. Long duration Treasuries (TLT) are significantly outpacing the S&P 500 year-to-date. In a classic sign of deflationary behavior, they are also outpacing intermediate-term Treasuries (IEF) as the yield curve is flattening. We wrote about the signaling power of Treasuries in a recent award-winning paper. In the paper, we showed that when long duration Treasuries are outperforming intermediate-term Treasuries, you tend to see higher volatility and a higher probability of a correction in equities looking ahead.
Defensive Sectors Leading
From early in the year, we also saw defensive sectors outpacing the S&P 500 and that remains the case today with the Utilities (XLU), Staples (XLP), and Health Care (XLV) sectors all up more than the broad index (see chart below). The behavior of the Utilities sector is particularly alarming as it has often outperformed preceding periods of higher volatility in the market, a concept we wrote about in our paper that received the 2014 Charles H. Dow Award.
Consumer Discretionary Weakness
Lastly, we continue to see the Consumer Discretionary sector lag the S&P 500, with a persistent decline in relative strength from the start of the year (see chart below). We saw similar behavior preceding the 2000 and 2007 tops, although it took time in both cases for the broad market to break down (in fact, 2007 was still an up year for the S&P 500). As it is the most cyclical of sectors and the most important sector in the U.S. economy, you never want to see persistent underperformance in consumer stocks.
Any one of these negative signals could be explained away on their own, but collectively they suggest caution is warranted until conditions improve. Again, market participants need to ask themselves the following question: how much longer can the S&P 500 hold up in the face of these red flags? My guess is that we’ll soon find out.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
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