Small Caps Are Lagging. Investors Should Be More Concerned When They Lead

Summary:  SPX made a new all-time high (ATH) last week. DJIA and NDX were not far behind. And the broadest measure of the US stock market comprising 98% of stocks came just 0.1% shy of a new ATH.

By contrast, small caps are lagging. They have retained none of their gains made over the past 1-1/2 years and haven't been close to a new ATH in 10 months. Should investors be worried?

By most measures, the answer is probably not. Small cap underperformance has more often marked a low in SPX, not a high. Investors should be more worried when small caps - which are highly speculative and high beta - lead, as this has most often been a feature of major bull market tops, the reverse of the situation we have now.

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Last week, SPX made a new all-time high (ATH). The DJIA equalled its ATH from October 2018 and NDX came within 1% of its ATH from just last month. The broadest measure of the US stock market, the Russell 3000, which comprises 98% of stocks, exceeded its May high and came within 0.1% of its October 2018 ATH. By most measures, US stock prices are doing well. Enlarge any chart by clicking on it.

An Extreme In Investor Fear And Pessimism

Summary:  Fund flows out of equities and into the safety of bonds is the most extreme in more than 15 years. Retail investor bearishness is consistent with that at Christmas, early 2016 and other durable lows in equities.

Fund managers surveyed by BAML are similarly pessimistic. Their cash allocation is one of the highest in 16 years. Their equity allocation is the lowest since the bear market bottom in March 2009. And their allocation to bonds is near an 8-year high.

All of this suggests a continued upside tailwind for equities and a strong headwind for bonds. Could investors, especially fund managers, be right this time? Of course, but it's not likely. The last bear market started with strong equity inflows and bond outflows. Cash levels were relatively low. All of this is the reverse now. 

The US dollar is considered the most overvalued in 16 years, a possible tailwind for US multi-nationals and ex-US equities.

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By most accounts, the fall in equities in May was exacerbated by investor fear. That fear does not appear to have dissipated with the rise in equities so far in June.

Let's review several recent studies of sentiment.

First, a study from Bernstein shows that flows out of equities and into bonds so far in 2019 is the most extreme in more than 15 years. Enlarge any image by clicking on it.

What The New High In The Advance-Decline Line Means For Stocks

Summary:  The cumulative advance-decline (A-D) line for both the NYSE and SPX made a new all-time high (ATH) last week. That's good news for stocks, as they most often move higher in the following weeks/months, also to new highs.

This is probably the best way to use the A-D line in equity research. Other common uses of A-D line are fraught with issues.

For example, while it's true that the A-D line has often weakened before stocks have encountered a major decline, you'll need hindsight to make use of this information. For every time a weakening A-D line has signaled a major fall it has signaled nothing special at least twice as often. "Negative divergences" happen all the time.  In real-time, it is impossible to know when a divergence is worth paying attention to.

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Last week, the cumulative advance-decline (A-D) line for both the NYSE and SPX made a new all-time high (ATH). The A-D line sums the net number of stocks moving up on the day added to yesterday's total.  The idea is that when the A-D line is rising, more stocks are moving higher and breadth is considered healthy. In other words, it's a bullish sign for stocks.

Let's start with the good news.

The charts below show every "breakout" in the NYSE A-D line to a new high (top panel) and what happened next to SPX (lower panel) in the past 30 years. What we find is that in every case, SPX has moved higher in the weeks/months ahead. Enlarge any chart by clicking on it.

June Macro Update: Employment and Housing Strong, Manufacturing Weak

Summary: It's been a noisy few months for macro. The prolonged government shutdown in December significantly delayed many data reports. Into this mess, several reports were ugly:

Retail sales in December fell into yoy contraction for the first time since 2009. 

New employment in February fell to the lowest level since 2010. 

New home sales growth in December dropped 14% yoy, the lowest rate since 2011.

That weakness now looks anomalous: the data from the past month mostly point to positive growth. A recession starting in 2019 is unlikely.

The bond market sees continued growth. The yield curve has 'inverted' (10 year yields less than 2-year yields) ahead of every recession in the past 40 years (dots). The lag between inversion and the start of the next recession has been long: at least 7 months and in several instances as long as 2-3 years. On this basis, the current expansion will likely to last through 2019 at a minimum (from JPM). Enlarge any image by clicking on it.

Don't Fear The First Rate Cut

Summary:  The Fed may soon cut rates and that prospect is making investors nervous. Is the start of easing necessarily bad for equities? In short, probably not, at least not immediately. There's more to it than that.

Equities have most often risen after the first rate cut. The only times when equities have consistently traded lower was when they were already doing poorly.

Moreover, the economic data had already been persistently weak for many months (even years) prior to the times when the first rate cut was followed by a recession and an equity bear market.  That's not at all the case this time, making it similar to years like 1984, 1995 and 1998 when rate cuts were subsequently reversed with further rate hikes.

There are never any guarantees but it's probably different this time, in a good way.

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The Fed is now expected to cut its overnight rate 3 times in the next year (from Jim Bianco). Enlarge any chart by clicking on it.

Weekly Market Summary

Summary:  US equities rose four months in a row and ended the month of April at new all-time highs (ATH). They then fell 4 weeks in a row during May, losing more than 6%.

So far, this is not that unusual. Almost every year has a drawdown greater than 5%, and most have at least 3 of these. What was unusual was the calm and steady rise from January through April, not the fall in May.

For the remainder of 2019, the evidence leans bullish. That's not a guarantee or a sure thing. But sentiment and breadth are close to a washout (they could be more so) and the usual set up is a seasonal low in June leading to a rally into July.

Could this time be different? Yes. For one, the US is engaged in a seemingly unending and escalating trade war with two major trading partners. No one knows how this will end and that uncertainty could well cause equities to plunge much further. All the market technicals, sentiment and fundamental data available cannot predict what happens next.

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US equities started May at new ATHs but ended the month more than 6% lower (table from alphatrends.net). Enlarge any chart by clicking on it.