June 8, 2015

Markets looking calm on the surface but below could be different

Today the market is like the anecdote about a duck. It looks serene gliding across the pond, but underneath the surface it's furiously paddling. The market is like that: you look at the price chart of the S&P 500 (SPY) and it just keeps gliding higher, while underneath the surface there's massive turmoil.

Consider:
   - New 52-week highs have been declining on every rally since February;
   - S&P 500 stocks over their 200-day averages have shown lower highs on every rally since last September;
   - Health care and technology are the only major sectors even close to maintaining breadth and momentum;
   - Utilities peaked in January's last week and are now nearly 10% below that top;
   - Energy stocks topped out in April 2014 and today are about 21% below that peak;
   - Transports made their highs in November and last week broke major support levels, standing 17% below their highs.

This paddling of the market's feet under the water's surface is typically a sign of a maturing market, but there's nothing typical about today's market. A market without memory from day to day -- in which big up days are routinely followed by big down days (and visa versa) -- isn't normal, although it's become the norm.

At the same time, volatility measures have been extraordinarily low, but the volatility of individual securities has been very high. Nor have index/group/sector breakouts had any followthroughs, although breakdowns have also been kept to a minimum.

How do we explain the serene market above the water's surface and a volatile market just below?

Perhaps the major individual and sector/share price volatility is a function of pronounced takeover activity that's now at record levels. Or perhaps it's the importance of financial engineering (share-buyback activity) that explains all of this.

Or maybe the market's inconsistencies and developing changes are a function of the markedly increased role of high-frequency trading, price-momentum strategies and the dominance of ETF trading.

The key question today is whether one believes that this "duck paddling" -- narrowing market participation and erosion in a number of leading sectors and stocks -- is a precursor of a larger correction, or whether the recent weakness is a healthy consolidation in preparation for another leg higher. 

Market history would say it's not "different this time," but the atypical nature of a market that's being smothered by massive liquidity and zero interest rates also merits consideration. Even with this unprecedented monetary stimulation (and ever more "cow bell"), subpar global economic growth has been the mainstay. For as Deutsche Bank recently commented, if Fed members "were brutally honest, what vestiges of optimism remain in the domestic sectors could quickly evaporate."

No doubt these are unusual times.

As The Oracle of Omaha remarked at this year's Woodstock for Capitalists:

    "We've done a lot of things that weren't in my Economics 101 class, and nothing bad has happened except that people who've kept their money in savings have gotten killed. But it's hard for me to see that if you toss money from helicopters, there isn't inflation. But I've been surprised by what has happened. We're operating in a world that Charlie (Munger) and I don't understand."

    -- Warren Buffett, 2015 Berkshire Hathaway (BRK.A) (BRK.B) annual meeting 


Based on market history, all this subsurface activity and deterioration would unequivocally be negative. But to some degree, the same could have been said a year ago. To still be grinding upward thanks to the world's central bankers (and other reasons) is nearly unimaginable.

In the 1999 to 2000 dot-com bubble things were out of sort. Valuations were stretched dramatically and overall participation was narrow. But the groups that were working were growing dramatically and some even exponentially. Yes, investors should have been discounting an eventual Post-Y2K deceleration, but at least in that era we had substantial top-line sales growth.

Today, we're trading at similar overall median stock multiples for many companies, but with only 2% to 4% revenue growth ex-energy. Margins have likely peaked and global growth is subpar, even after massive stimulus.

    "If we get normal interest rates, stocks will look expensive."  - Warren Buffett, 2015 Berkshire Hathaway annual meeting 

And yet I still listen to intelligent money managers say things like: "But where can I make money?" or "Bonds are just as risky if not more risky than stocks!"

When people argue that they aren't making money in bonds, it assumes that they won't lose money in stocks -- which is, frankly, totally inane (if not insane). 

Numerous acquaintances in the hedge-fund business tell me that they're scared because they could lose 10% in bonds. At the same time they don't think stocks can go down more than 10%.

They ask in light of this, "Why sell stocks?"

"T.I.N.A." ("there is no alternative") has been the bullish mantra for years. And in a bull market characterized by zero interest rates, there's no alternative to zero -- until stocks deflate and investors grow concerned that the return of capital eclipses the objective of seeking a satisfactory return on capital.

We're not at maximum bullishness -- that passed a year ago. Though the overwhelming view by most market participants is that "stocks could pull back, but not enough to justify getting out of them," I will state without qualification that we are now at maximum complacency.


It's almost as if Daffy Duck has taken over the market's pond these days. Let's call this the Summer of Looney Tunes. 



Originally published at http://www.thestreet.com/story/13172333/3/kass-this-market-looks-as-serene-as-a-duck-but-theres-turmoil-underneath.html

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