The Stock Market’s Rebound – Internals Are Weakening

The Nature of the Latest Rally Leg

Keeping in mind that a number of important historical market peaks have been recorded in late August/early September, here is a brief look at how the most recent rally leg stacks up in terms of its internals. It can definitely be stated that the technical condition of the market has weakened further (the same happened already on the preceding rally leg, but it has become even more pronounced now).

Specifically, it can be seen that the market is carried higher by fewer and fewer stocks. The underperformance of the small cap vs. the big cap sector has continued, but that is not the only evidence of narrowing we have.

Whenever a stock market rally becomes narrower, it essentially conveys the information that market liquidity is becoming less ample. There is no longer enough additional liquidity entering the market to enable the tide to lift all boats concurrently. Given the fact that most indexes are capitalization-weighted, their performance can easily mask underlying deterioration. It makes therefore sense to keep an eye on the market's innards.

Small caps on average sport higher valuations than big caps, and generally need more plentiful liquidity to rally. Moreover, they tend to be more economically sensitive, as smaller companies are likely to largely depend on the performance of the domestic economy.

The Russell 2000 index is still weakening vs. the SPX. It is probably no coincidence that this has happened in conjunction with a decline in treasury yields

If we look at one of the best performing big cap indexes, the NDX (Nasdaq 100), we can see that its internal condition has been weakening for some time as well:

The NDX has moved to a new high, but new highs are becoming fewer with each rally leg this year, the bullish percent index (percentage of NDX stocks on a point & figure buy signal) is negatively diverging from price, as are the NDX stocks above their 200 and 50 day moving averages. Trading volume has also declined to a new low for the year last week

Looking at similar indicators on the SPX, the same picture emerges:

At the recent high the SPX diverges from RSI, the bullish percent index, and new highs have likewise contracted sharply compared to previous peaks. A noticeable decline in trading volume is evident as well

The most recent rally leg differs in an additional respect from previous advances – it is so far not confirmed by European stock market indexes. While NDX and SPX have managed to streak to marginal new highs, the major European markets have so far been unable to regain their peaks from earlier this year:

Germany's DAX index and the CAC-40 in Paris are both diverging noticeably from the SPX in the most recent rebound

To this it should be noted that in Europe, annualized growth in money TMS is over 3 percentage points lower than in the US. At around 5%, money supply growth in the euro area is probably not too far away from a potential “crisis point”. This is already reflected in numerous economic data as well, which have displayed quite a bit of weakness so far this year.

Japan's market on the other hand seems to be benefiting from a short term weakening of the yen. The US dollar's recent rally against the euro has spilled over into the yen a bit. Note though that over the medium to longer term the yen is likely to strengthen again, as Japan's money supply growth is also slowing down at the moment and has actually so far failed to accelerate much in spite of the BoJ's 'QE' exercise. Obviously, Japan's commercial banks still see no reason to expand domestic lending.

The Nikkei and the yen, weekly. Note the 60-period correlation depicted in the middle of the chart. For quite some time the yen's negative 60 period-correlation with the Nikkei was close to a near perfect -1; recently it has been somewhat less pronounced at -0.75. However, this is still quite significant.  The Nikkei's weekly chart actually looks reasonably good, but the market is clearly vulnerable to a potential strengthening of the yen

Finally, here is an update on Rydex data as a sentiment and positioning snapshot. There have been a few changes recently: a small spike up in money market funds, and a strong increase in volatility in the bull-bear asset ratio. As can be seen, this is very similar to how the ratio behaved in 2000, including the fact that there bear assets remain almost unchanged – in other words, the volatility is almost solely the result of changes in bull assets.

Rydex money market funds, bear asset, the bull-bear asset ratio and the SPX. Note the sharp increase in the bull-bear asset ratio's volatility, which mirrors what occurred in 2000

Conclusion:

When the market recently dipped, we pointed out that one would have to closely watch the subsequent rebound for clues. From a technical perspective, this most recent leg of the advance has been the weakest yet this year, in spite of several indexes eking out new highs. The probability that a more significant downturn is in store has accordingly increased. The fact that the market hasn't suffered a significant correction in a very long time is problematic as well in this context. The longer volatility remains extremely low, the larger it is likely to be when it finally comes back.