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Market Internals Show Deterioration, Trend Still Bullish For Now

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    March 14, 2014

    This past Monday I penned a piece entitled “10 Signs Of Stock Market Exuberance” which detailed some notes from the discussion that I recently had with another portfolio manager.  Interestingly, this article received a series of diametrically opposed opinions from “why are you so bearish” to “why aren’t you recommending all cash in portfolios.”   Of course, having two opposing sets of opinions is what makes a market in the first place but this does raise a good opportunity to take a look at the health of the current market rally.

    If you are a regular reader of my weekly newsletter then you already know that we are currently at 100% of target allocations.  The mistake that many individuals make is assuming, with regard to Monday’s post, is that if I express concern about particular aspects of the market that means I am “bearish” and must be “all in cash.”  In fact, expressing a“bearish view” in the current market environment almost rises to the level of heresy (thank goodness that “burning at the stake” has been outlawed, at least for now.)  However, if you want the “bullish view” just turn on the television, pick up any financial editorial or scroll the internet; finding an unbiased non-bullish discussion is about as rare as a “Yetti” sighting these days.

    In my view, the real risk is adopting a viewpoint that is inherently “bullish” or “bearish.”  This is a trap that investors fall into that leads to “confirmation bias” where opposing opinions are disregarded.  For investors, this is ultimately fatal.  For me, the markets are either “rising” or“falling.”   The financial media primarily exists as a coincident indicator only telling me what I already know.  What I need to know is what may cause the current “trend” to change.  More importantly, when is the current “risk” I am taking with my client’s money outweighed by the potential “reward.”

    With portfolios currently fully exposed to the market, the “risk of loss” has been elevated.  Therefore, like a doctor/patient relationship, we can monitor several internal indicators of the markets health in order to gauge the when the “risk” exceeds the potential for “reward.”

    Net New Highs

    The first internal measure I want to examine is the number of NET new highs.  This is the number of stocks hitting new highs less the one hitting new lows.  In an “exuberant” bull market, you would expect to see the number of net new highs at very high levels.


    What the chart above tells us currently is that the number of net new highs is declining.  This is typical as markets become exhausted during a bullish phase.  Unfortunately, net new highs are only useful in indicating a potential correction, but not when that correction turns into a more meaningful reversion.  Therefore, declining net new highs, as markets are rising, should be treated with equal caution.

    Advancing Versus Declining Issues (Market Breadth)

    Another measure of the internal health of the market is its “pulse.”  One way to look at this is the “breadth” of advancing versus declining issues.


    When the breadth of the market is advancing, as it is now, the markets are within a bullish trend meaning that investors should be exposed to risk.  The problem with market breadth is that it is historically not a very precise market timing indicator and, like net new highs above, doesn’t distinguish between short term corrections and full blown reversions.  Therefore, declines in market breadth should not be ignored and evaluated within the context of the overall trend of the market.

    Number Of Stocks Above Their 200 Day Moving Average

    In a rising bull market the number of stocks above their 200 day moving average (dma) would be expected to be high.  The longer the bull market has run, the higher the number of stocks above their individual long term moving averages will be.  Deterioration in the number of stocks above their 200 dma is a warning that a potential correction is in the making.


    The chart above shows historically when the percent of stocks above the 200 dma have peaked, and began a decline, market corrections have quickly followed.  The problem with this indicator, as with the other measures discussed herein, is the inability to determine when a correction becomes a “mean reverting” event.

    Number Of Stocks On Bullish “Buy” Signals

    Another measure of market “health” is the number of stocks on “bullish buy signals” as determined by “point and figure” analysis.  Again, the longer a bull market has been in process, the higher the number of stocks on bullish buy signals there should be.  Historically, as shown in the chart below, when this indicator has turned lower corrections were generally soon to follow.


    The current period is the longest since 2004 where the bullish percent index has peaked and turned lower without a significant correction.  The deterioration in the index certainly suggests a much higher risk profile in the market as the bullish strength weakens.

    Long Term Moving Average Convergence/Divergence

    As I discussed in Monday’s article, all of these indicators are “warning signs” that there is potential danger ahead.  That danger could range from a mild correction of 5-15% or something much more mean reverting in nature which could easily approach 30% or more.

    What these indicators don’t tell us is when the current trend is changing from positive to negative.  As Bill Clinton once stated “What Is…Is.”  In the world of investing there really is no “bullish” or “bearish” view, it is simply what “is” until “it isn’t.”


    The chart above shows the market as compared to a long term moving average convergence/divergence (MACD) indicator.  What this indicator clearly shows is when the “price trend” has turned from positive to negative and back again.

    The current bullish trend remains intact which suggests that portfolios remain fully allocated at the current time.  However, the ongoing deterioration of the “market internals” also suggest“attention” be paid to portfolios.  The “easy money” is long behind us and we are only“marking time” until the next correction or major market reversion.

    While the Federal Reserve may have inflated asset prices through continued rounds of liquidity, they have not repealed either economic or market cycles.  The sustained levels of investor complacency, a complete disregard of investment risk and fundamentals, and the continued stretch for yield is a toxic brew that has always ended badly.  This time will be no different.

    That last paragraph is not a “bearish” viewpoint, it is just a fact of what currently “is.” As a portfolio manager, I must remain invested in the markets when the trend is positive or suffer“career risk.”  That is also a fact.  However, understanding when the light at the end of the tunnel is, in fact, an oncoming train is what defines the “long game” of investing.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.


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