Big Cap Head Fake—–Mind The Divergences Below


Negative Divergences Persist

Following Friday’s payrolls report, the stock market rallied quite a bit, although it is not really clear why. It sold off a day earlier, allegedly out of “disappointment” over Mario Draghi not inflating enough (which is utterly absurd), and then rallied on Friday on growing certainty that Ms. Yellen would soon act to slow down monetary inflation further. It simply doesn’t make much sense.


dsmPhoto credit: Rene Mansi / Getty Images



However, all of this is only relevant if one looks at the popular indexes and averages that are driven by big caps, or let us better say, are largely driven by the “nifty five”, or the “nifty ten” if one wants to be generous. Thus SPX and DJIA are not far off their 2015 highs. Things look quite a bit different looking at broader indexes and small cap stocks. Below is a 2-hour chart of the broad NYSE Composite Index (NYA) since its peak in May– originally a good friend sent us a version of this chart with a similar annotation, referring to it as “heresy”.


1-NYAThe NYSE Composite Index, 2-hour chart since its peak in May. The current rebound looks more like a correction than a genuine resumption of the rally. The bounces are weak compared to SPX, DJIA, COMPX and NDX, and there are many overlapping waves (a hallmark of corrective moves) – click to enlarge.


Given the ongoing enthusiasm for big cap stocks with triple digit P/E ratios and current favorable seasonal trends, it seems conceivable that some or maybe even all of the big cap indexes will make new highs that once again won’t be confirmed by the broader list of stocks.

The Russell 2000 Index (RUT) offers an analogous picture:


2-RUTRussell 200 Index (RUT) – this wedge looks bearish as well at the moment – click to enlarge.


Along similar lines, the Dow Theory sell signal that was triggered in August this year – after many months of diverging prices – remains in force (the sell signal occurred when both the Industrial and Transportation Average broke below their previous intermediate terms lows, thereby “confirming” the trend).


3-Dow TheoryThe August Dow Theory sell signal remains in force as no countervailing upside confirmation has invalidated it. Moreover, the Dow Transportation Average looks bad – it has just broken below wedge support – click to enlarge.


If one looks at a ratio of the Russell 2000 and the SPX, one can see that the RUT has outperformed roughly until the end of “QE3”. Ever since, it has been immersed in a volatile downtrend relative to the big cap index.


4-RUT-SPX ratioThe ratio of RUT to SPX since early 2013. Small caps were leading and outperforming the market until early 2014, when “QE3” ended. Since then, US money supply growth rates have begun to decline, albeit grudgingly (the same is obviously not true for euro area money supply, which is still growing by leaps and bounds due to QE) – click to enlarge.


5-TMS-2 and bank credit growthAnnual growth rates of the US broad money money supply TMS-2 (black) and total bank credit (red). After a long-lasting sideways movement, the broad money supply growth rate is beginning to break down, led by narrower gauges such as TMS-1 (AMS) and M1 – click to enlarge.


Junk Bond Market not Invited to Friday’s Party

Below is a daily chart of the junk bond ETF JNK (unadjusted price only chart). While the stock market rallied strongly on Friday, junk bonds mainly just sat there. Evidently this market doesn’t quite believe that all risks have magically disappeared (although it may actually be close to a technical short term low judging from the shape of Friday’s daily candle). In fact, JNK declined to a marginal new low for the move on Friday.


6-_JNK, dailyJNK, daily – not joining any parties yet – click to enlarge.


Probably more interesting than this daily chart of JNK is an overlay of the weekly charts of SPX and JNK, which shows since when their trends are diverging. Interestingly, the divergence started well before crude oil began to go into free-fall. Importantly, it has persisted for almost 18 months by now.

In the past such divergences have never led to a happy outcome, and the longer they have lasted, the less happy the outcome as a rule turned out to be. In August, the stock market for the first time attempted to “catch down” with the credit markets, but in the meantime a large gap has reopened between the two.


7-JNK-vs-SPXSPX (b/w candles) vs. JNK, weekly, since 2011. Until June 2014, the two have trended in the the same direction without producing major divergences. Since then, trend uniformity has been lost – click to enlarge.


In its most recent monthly Financial Forecast, Elliott Wave International shows a chart of the number of trades in the bonds of distressed issuers. It is quite remarkable how big a jump in trading in this market segment has been seen so far this year. The 2011 interim peak has been well exceeded.


-distressed bond tradingTrading in distressed bonds, via EWI


Evidently, the number of issuers in conditions of “financial distress” is rising quite sharply – and it is interesting that the most recent bottom on this chart was made in late 2013/ early 2014, also around the time when “QE3” was close to ending. A secondary low in mid-year coincided with the all time low in junk bond yields.

Readers may recall that we have discussed the “low expected defaults trap” at the time, warning that extremely low default expectations were a clear contrary indicator for this market sector (see “A Dangerous Boom in Unsound Corporate Debt” for details on this). This has by now been confirmed in spades.



Seasonal strength may continue to support big caps for a while longer, but any new highs in this segment will once again fail to be confirmed by the broader market, small caps or high yield bonds. Note in this context also that there continue to be strong divergences between developed and emerging market stock markets, and to a lesser degree between US and European stocks as well.

Persistent, long-lasting divergences between these different “risk asset” sub-sectors have in the past always been a warning of difficult times to come. To argue that it will be different this time requires a lot of faith, not only because it never is, but also in light of the renewed slowdown in US money supply growth (there was a first sharp slowdown period between 2011 and 2013). This slowdown is likely responsible for the growing weakness in manufacturing activity as well.

In some ways the market is reminiscent of both late 1972 and late 1999. The main similarity are the divergences discussed above and the tendency of the group of winning stocks to become ever smaller, while at the same time reaching ever more absurd valuations. As always, all of the underlying companies have a good “story” and in many cases it is justified. What is hard to justify are the prices paid for these stories, no matter how good they sound.


Charts by: StockCharts, St. Louis Federal Resrve Research, Elliott Wave International