Saturday, September 27, 2014

More on the Diverging Market Internals in the US and Global Stock Markets

Last weekend I wrote (bold original):
Trends are built or decayed over a period of time. Market cycles undergo transitional stages. Trends or cycles don’t happen just because. Trends or cycles happen because of the underlying incentives guiding the market participants to act. If the incentives guiding people’s actions changes, due to say social policies, then naturally, the market’s response will eventually reflect on such direction of changes.
This applies to trend reversals or inflection points. Such major critical pivot points don’t happen just because, they happen at the margins in response to changing conditions

I’ve pointed to divergences or deterioration in Market Breath of US and European Stocks as well as the MSCI World Index.


Yet more pictures of divergences

In US stocks…
image
…with only 38% of S&P 500 stocks above 50dma (or 62% below) even a perma bull the Bespoke Invest admits: "breadth has been weak for months now, with this reading not getting close to its one-year highs even as the market traded to new all-time highs recently."

image

Yet more unraveling of the Nasdaq and Russell 2000 advance decline spread as shown above from Bank of America/Zero Hedge

Note that small caps are not included in the MSCI World indices

These divergences would be the financial market equivalent of periphery to the core dynamics where small caps appear to be weighing on the market cap heavyweights

Yet snother major divergence has been in the margin debt
image

The Zero Hedge warns (bold underline original): But, the biggest concern, as BofA warns, a new low for net free credit at -$182 billion is a major risk should the market drop..Net free credit is free credit balances in cash and margin accounts net of the debit balance in margin accounts. Net free credit dropped to -$182b and moved to a new low below the prior record of -$178b in February. This measure of cash to meet margin calls remains at an extreme low or negative reading below the February 2000 low of $-129b. The risk is if the market drops and triggers margin calls, investors do not have cash and would be forced to sell stocks or get cash from other sources to meet the margin calls. This would exacerbate an equity market sell-off.

Here is how I defined the would be end of the mania process
And like typical Ponzi schemes, the manic process goes on until the ‘greater fools’ run out, or that every possible ‘fool’ has already been “IN” (crowded trade), or that borrowing costs has reached intolerable limits to expose on foolhardy speculative activities
With cash levels at extreme lows, a reemergence of a risk OFF scenario would entail "margin calls". This means that in order to sustain equity positions, levered participants would need increase equity collateral by most likely borrowing at higher costs or be forced to liquidate. 

Back to the MSCI World Index, Gavekal’s generous Louis Gave (via zero Hedge) notes of the thinning market leadership (bold italics original): "First it was the foreign exchange markets, then commodities, followed by fixed income markets. Now it’s the equity markets. Wherever we look, volatility has been creeping higher. To some extent, this is not surprising. At the end of the US Federal Reserve’s first round of quantitative easing, and at the end of QE2, the markets wobbled. So with QE3 now winding to a close (and with the European Central Bank (ECB) still behind the curve), a period of uncertainty and frazzled nerves should probably have been expected…."
image

"…Putting it all together, it is hard to escape the conclusion that the environment for stocks is turning ugly:global growth is disappointing , liquidity and momentum deteriorating, and markets are starting to act abnormally. When you consider that September and October are often challenging for equity investors’ nerves, perhaps we should not be surprised by the recent wave of profit-taking."

Thinning market leadership and narrowing breadth of gainers relative to losers, as well divergent signals from different markets (US dollar, bonds, commodities) has been a symptom of a global periphery to the core dynamics in the context of financial markets.

The Gavekal team also points to the weakening of financial bellwethers for both a Developed economies and Emerging markets and their role in the MSCI World Index (bold original, italics mine)
When it comes to global equity returns, the financial sector matters for one simple reason: financial stocks dominate global stock exchanges. Looking at the MSCI All Country World Index, which includes the 23 developed countries in the MSCI World Index and the 23 emerging countries in the MSCI Emerging Markets Index, nearly 23% of all stocks are financial stocks (552 stocks out of a total of 2449 stocks). Financials account for 7.5% more of the index than the second largest sector (industrials) and 8.5% more of the index than the third largest sector (consumer discretionary). There are more financial stocks than there are energy, health care, utility and telecom stocks combined. Surprisingly, financials almost equally dominate developed market indices as they do emerging market indices. 21.2% of all developed market stocks are financial stocks and 25.1% of all emerging market stocks are financial stocks. Out of the 46 country indices, just about two-thirds have more (or equal) financial stocks than any other sector. If you are are on the lookout for MSCI Country indices where financials aren't the dominate player, then look here (in alphabetical order): Canada, Chile, Czech Republic, Denmark, Finland, France, Germany, Japan, Korea, Mexico, Netherlands, New Zealand, Norway, Peru, Russia, Sweden, and Taiwan.
With all of this in mind, the chart below is even more remarkable, The MSCI All Country World Index has increased by 52% over the past five years. During this time, the financial sector has underperformed by over 17%.
image

Will these periphery to the core process eventually get reflected on major equity benchmarks? Or will a deus ex machina reverse such entropic trends in motion?

2 comments:

wilfrid said...

Some technician see a stock market that is deeply oversold when looking at breadth indicators and expect that we may see a market recovery into the end of the third quarter.

benson_te said...

Thanks for your comment, Wilfrid.

The problem with technical interpretation is that it is usually subject to the interpreter’s bias. For instance there may be two or more patterns present on a chart at a given moment, but the technician will choose from his preferred angle. This is why I refrain from interpreting technicals on a standalone basis.

The reason I demonstrated several technical perspectives here has been because they seem to dovetail with theory as with other financial signals, rallying bonds, commodities and firming US dollar. Such evolving convergence seems to give a bigger weighting on the probability of market moving towards a certain direction. Especially since governments time and again intervene, there will be noises. But in order to ascertain the validity or falsifiability of the market trends we need to observe the flow of the signal (or process). If indeed we are seeing decay spreading then the divergences will first amplify and eventually will lead to a convergence. But such convergence may indicate market moving in a contrasting direction as against mainstream’s present expectations.

Hope this helps,

Benson