This Divergence is not Good for Stocks

Today I’m going to show you more evidence of the fragile nature of this equity market rally.

Before I do though, a quick thank you for your feedback on the land tax issue from Tuesday’s essay. You might recall, I ran an essay from Phil Anderson, editor of the Cycles Trends & Forecasts publication.

Admittedly, my knowledge of the issue is not as strong as it should be. I’m catching up with Phil soon, so will discuss with him further (and will mention some of your objections) and get back to you.

Also, I recorded a video update earlier this week, which I forgot to send yesterday. It’s still relevant though, so feel free to check it out here.

Right then, let’s take a look at the US markets, shall we?

You may remember I have previously written that the key index to watch is the NASDAQ. It led the bull market higher, and I have argued that it will lead us into a bear market as well.

For some perspective on where we are right now, have a look at the longer term chart of the NASDAQ below. The recent rally has been impressive. It’s up 20% from the lows.

But when you look at it from this longer term perspective, you can see that the trend is still down. The moving averages have yet to cross back to the upside.

To me, this looks like a prolonged topping out pattern. That is, you saw an increase in volatility at the start of 2018, followed by a final rally into a September/October peak. Then a sharp sell-off, followed by a hopeful recovery.

NASDAQ 14-02-19

Source: Optuma

[Click to open in a new window]

Whether it’s for an index or an individual stock, topping out patterns are characterised by what is known as ‘distribution’. Distribution occurs after a sustained move higher. It refers to those who got in early in the bull market ‘distributing’ their stock to the late comers.

These patterns come with an increase in volatility. And that’s exactly what you’re seeing here. After a strong and volatility free bull market from late 2016, the volatility picked up markedly in 2018. That’s distribution occurring.

I believe we’re still in that process. When it’s finished, I believe there is a decent chance prices will bottom out around the green dotted line.

What’s driving the latest rally?

This latest rally has been driven by two things: A realisation that sentiment turned too bearish, too quickly, and the hope that an easier Fed will make everything better.

Correcting the first thing makes sense. The US and global economy was clearly slowing as we headed into 2019, but things weren’t as bad as the market feared. They rarely are.

The second one though is a little more dubious. The Fed is easing off on rate hikes precisely because the economy is slowing. Yes it helps liquidity and sentiment, which in turn supports asset prices. But it’s not a reason to expect a sustained bounce, and certainly not a reason to expect a move to new highs when the economy is slowing.

The chart below gives you a good idea of the market’s irrationality right now. It shows the US 10-year bond yield…

10-year Treasury Note Yield 14-02-19

Source: Optuma

[Click to open in a new window]

Yields shot up to around 3.2% in September on the view that the US economy was expanding at a decent clip and that the Fed would continue to raise rates as it said it would.

But it quickly became apparent that view was wrong. In the final months of 2018, the bond market rapidly reassessed its view.

Here’s where it gets interesting. Unlike the equity market, yields rallied only temporarily. They hit resistance at 2.8% in mid-January and turned back down. Falling yields indicate a slowing economy.

In other words, the bond market has a completely different view of the world to the equity market.

Who’s right?

My money is on the bond market. In my view, it’s more rational and less driven by sentiment than the equity market is.

That doesn’t mean the divergence between bonds and equities can’t persist. If enough investors believe that lower rates will prop company earnings up, then that belief will sustain higher share prices.

In that case, it will take a negative earnings announcement from a prominent company to shift the narrative back to earnings risk.

If and when that happens, prices could fall very sharply to the downside.

Forewarned is forearmed…

Regards,

Greg Canavan,
Editor, The Rum Rebellion


Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own.

Or worse, we only seek out the voices who are confirming our biases and narrowminded views of the truth. Either situation is not ideal. With regards to investing, this makes us follow the masses rather than our own gut instincts.

At The Rum Rebellion, fake news and unethical political persuasion are not in the least bit tolerated. It denounces the heavy amount of government influence which the public accommodates.

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