MorningWord 5/13/14: Rorschach Test

by Dan May 13, 2014 8:56 am • Commentary

See below.  It’s a 6 month chart, of what?  Well whatever it is, it looks pretty darn healthy, with rising 50 day (purple) and 200 day (yellow) moving averages, and a new closing high for the period:

spx6

This is a chart of the same security since the year 2000.  Once again, looks healthy, maybe of body, but certainly not of mind.  The 185% gains off of the 2009 lows, and the runaway breakout above the 2007 highs is completely mental:

spx14

If this security were a single stock, one might say, “oh yeah that must be a biotech stock that got approval for a drug that cures a disease. Or maybe an electronics company that has had a string of consumer products hits. Or possibly an investment bank that came up with some new innovative way to package bad assets and charge high fees on products to unknowing brokerage clients.  But no, most of you know that this is a chart of the S&P 500 index, made up of most of the largest companies in the world, and often used as a barometer of the health of the largest economy in the world.

I have made the argument on many occasions of late relating to 3D stocks or social media stocks, that just as they overshot on the upside, they are likely to do so on the downside.  That is an easy statement to make about single stocks, but harder to make about the largest equity index by market cap in the world.

We have gone out of our way on many occasions in the last couple months to avoid trying to pick a top in the SPX, largely due to its impressive relative strength, building consolidation near the highs, and the simple notion that investors appear to be viewing the index as a safe haven asset.

Yesterday’s close of the SPX marked its highest close ever, and the short term set up looks attractive for those who like to play technical breakouts.  Michael Batnick, who writes The Irrelevant Investor blog made an interesting observation about the SPX’s relative performance in a blog post Sunday, specifically the relationship between the Russell 2000 and the S&P 500 over the last 14 years (emphasis mine):

The Russell 2000 had a fantastic 2013, delivering returns of 36.8% which was its best year since 2003. The first five months of 2014 have not been as kind. Small-caps are only down 4.5% YTD, but Friday marked a 10% peak-to-trough decline which hasn’t happened since November 2012The index just recently closed below its 200-day moving average, also for the first time since November 2012. 

This is small caps’ 36th peak-to-trough decline of at least 10% since 2000, with an average decline of 17.1%. Of the first thirty-five corrections, every one of them were accompanied by large-caps also falling, until now (an average decline of 12.8%).  The thing that has people scratching their heads is why large-caps have been blessed with impunity while small-caps have begun to roll over. The Russell 2000 is 10% off the recent highs and the S&P 500 up 0.12% over the same period. 

The Russell had a very nice bounce yesterday, more than doubling the 1% performance of the SPX, but for those of us who have been pressing weakness on the short side, primarily in the Nasdaq, we will be keeping a very close eye on the strength and breadth of the bounce in the Russell and the Nasdaq, despite yesterday’s out-performance.  If they were to fail at logical resistance (basically their 50 day moving averages and at the downtrend), our trade would be emboldened, but a close above will likely cause us to scramble and cover shorts, as overstaying one’s welcome on the short side has generally been a costly endeavor over the past couple of years.

This is a tough spot to judge.  A number of indicators are signaling waning risk appetite among investors (growth stock weakness, sector strength / weakness, higher Treasuries, overall market internals, etc.).  However, that occurred on several occasions in 2013, and the market eventually blasted higher to new highs each time.  2014 has behaved differently, and if the new year maintains that novel tone, then yesterday’s breakout is likely to fail, and soon.  If it’s a return to the 2013 playbook, however, then the SPX breakout will heal the divergences.

Regardless, we’ll stick to single stocks for most of our ideas, looking for attractive setups based on fundamentals, technicals, and volatility.  With the end of earnings season, those ideas are more likely to be based on the first two factors as low volatility pervades the bulk of the options market.