Market internals can tell us a lot about the overall health of our equity funds. Healthy rallies are ones where most of the stocks are participating. We also like to see strong volume during the rallies. Volume is the amount of buying and selling. If the market rises on low volume and declines on high volume, then the market is weak. In the charts below we see why the NYSE Advance-Decline Volume Index has been weaker than the NYSE Price Index lately.
Narrow based rally dominated by big names
The current rally has been narrow and dominated by a few large companies. In the first chart we see the recent action of the largest 50 companies (teal) compared to the other 450 companies (red) within the SP500 index (TSP C fund). Notice how the SP500 index (black) falls in near the middle of the other two lines. The largest 10% of the SP500 companies account for the bulk of the market’s value and heavily influence the indexes price.
Another indication of weak internals is the fact that only 45% of the companies within the SP500 were trading above their 200-day moving average as the SP500 moved back to within 2 1/2 percent of its all-time high on 26 October. It all points to a narrow-based rally similar to the one seen in July.
The Nasdaq 100 rules
The largest 100 companies of the Nasdaq exchange or the Nasdaq-100 index have been the place to be invested the last decade. In the chart below we see the Nasdaq 100 almost tripled the performance of the SP500 index. This index outperformed even the non-SP500 companies (TSP S fund seen in red) and the medium cap stocks of the SP50o (dark blue).
The Nasdaq Exchange lists most of today’s dominate companies: Apple, Amazon, Google, Microsoft, Facebook etc. These stocks are holding the market indexes up today. If they give way, then look out below. My favorite chart of the week is the one below of the Nasdaq 100 index. Notice inside the flying saucer the last three days of trading for the index. This index is levitating just below its summer high after gapping up four days ago.
Why do I bring the NASDAQ up? The SP500 index (TSP C fund) invests in the leading US companies listed on the New York Stock Exchange and the NASDAQ. You own many of these companies if you are invested in the SP500 index. These exchanges also list foreign companies, so you do not own all of them in the US equity funds. The same companies that propelled the Nasdaq 100 up last week, pushed the SP500 to its recent peak.
A Leading Sector is Faltering
We have also seen some changes in the sectors within the indexes. Healthcare had been a leading sector during the bull market but after the August plunge it has remained in a downward trend. The energy sector which has been declining since the summer of 2014 staged a relief rally over the last month helping support the overall indexes. The black line represents the SP500 index (TSP C fund) made up of these sectors and others. If the healthcare sector remains in a downtrend, the market’s rallies will be muted.
The energy sector may have been the canary in the coal mine peaking in the summer of 2014 much like the home builders index led the 2007 stock market top by over a year. The Dow Transports peaked in late 2014 since much of the transports advance had to do with the shale industry. So the downturn in oil finally hit the transports after some delay thanks to the futures market.
Financial Tail Wagging the Economic Dog
With no pipeline to move oil out of South Dakota, several rail companies (transports) were operating at capacity and earning top dollar. After the plunge in oil prices, the shale oil companies were able to continue pumping at high levels thanks to their hedges in the futures market that continued to pay them at profitable rates for their oil production.
Without hedging in the futures market, the oil shale companies would have immediately reduced production when oil price declined below their costs. This would allow supply to stabilize near demand sooner. With the older hedges now expiring the shale oil companies are finally pumping less and this should help to put a floor on the over-supply of oil (but not necessarily the price).
Financial engineering delays the normal feedback loops that allow markets to correct gradually instead of abruptly. China provides us another example.
In China, commodity warehouses were using inventory as collateral for obtaining loans from the shadow banking system to invest elsewhere. With the stock market plunge many loans turned bad and with the commodities price also plunging the collateral is worth less than the loan. There is a lot of financial damage within China.
China’s regulators recently outlawed the use of commodities are collateral for loans shutting down the shadow banking system and forcing banking back into normal channels. Much of the financial media’s talk about the recent credit growth in China (taken as a positive) may actually be the shift from shadow banking to normal banks and not actual credit growth.
Since commodities can no longer be used as collateral, there is no reason for the warehouses to sit on inventories. This could lead to significant supplies of commodities being dumped onto an already weak market. With weak demand in the first place many of the countries who export commodities to China may be waiting a long time before demand comes back and their exports grow again.
The two leading sectors during the bull market were Healthcare and Consumers. Since the August decline, healthcare has been the worst performing sector and remains in a downtrend. The energy sector had a relief rally and saved the SP500 index from deeper declines during the correction.
If the energy sector resumes its decline and healthcare continues its weakness, the broader markets will have a hard time advancing. This matters most for the small cap indexes such as the TSP S fund. The large cap SP500 index needs the mega companies to hold their gains and continue to climb or for the broader market to rebound in order to advance.
The world and the US are in an industrial recession. With manufacturing only accounting for 18% of the US economy today, the US economy as a whole is less impacted than the rest of the world. The consumer sector needs to remain robust to keep a floor under the US economy.
But the stock market is not the economy and other factors are weighing in today that we need to watch. The financial markets were not driven to all-time highs based on the weak economic recovery. And a weak economy can not prop up the financial markets (stock market). There is much more at play.