The Bear Case for US Stocks

For most of this year, we've been writing about the overwhelming amount of bullish evidence for U.S. equities. However, as part of our "weight of the evidence" approach, we're always questioning our thesis (i.e., here and here).

In today's post, I want to share that exercise as I perform it, outlining some current concerns and what the market would potentially look like in an environment where stocks as in the U.S. as an asset class are falling. We're going to stick with our top-down approach and start with international equities and inter-market relationships, then drill down into specific examples that help illustrate what we're talking about.

In early July, we spoke about the slight deterioration in Global Equity Market breadth, but we pointed out that shifts from uptrends to sideways in many of these markets were not inherently bearish. What we didn't want, and still don't want, to see is a resolution of those sideways consolidations to the downside rather than the upside. Since that post, we've still not not seen a decisive shift one way or another in total uptrends or downtrends.

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First off, let's start with equities as an asset class. Since the U.S. Dollar Index bottomed in mid February, emerging markets as a group have lagged behind their developed market counterparts. While this relationship has begun to stabilize over the past few weeks, the chart continues to suggest that it's range bound at best or continuing its downtrend at worst.

Emerging markets vs. developed markets

Within the emerging markets space, countries like Brazil that have commodity exposure are being hit the hardest. Others like India that have a larger emphasis on IT and consumer goods have outperformed on a relative basis and continue to do so. If there's any group that's going to lead us to the downside, it's going to be those emerging markets with exposure to commodities, like Brazil.

Brazil Bovespa

On the other hand, developed markets like the German DAX have struggled to make upward progress and are testing important support levels like the one shown here. In a market where U.S. equities are heading lower, we'd likely see many of these consolidations resolving to the downside.

German DAX

Sticking with Europe for a second here, the relative performance of European financials versus the EuroStoxx 50 is a risk appetite barometer that we want to see trending higher, not range bound like we're seeing here. A break of the recent lows is something we'd likely see in an environment where stocks in the U.S. and globally are breaking down.

European financials vs. European markets

For those markets like Taiwan that have been showing relative strength, a break below key levels (in this case former resistance dating back to 1990) would be another bearish development that would get our attention.

Taiwan Stock Exchange

In the bond market, we typically like to see high-yield bonds outperforming investment-grade bonds and Treasuries to signal risk appetite, yet throughout 2018, we've not seen these spreads participate to the upside as equity markets trend higher. The continued stagnation or a resolution to the downside is not something we want to be seeing. Bulls want these ratios to resolve their recent ranges to the upside and momentum hitting overbought conditions. We've not seen it yet.

High-yield bonds vs. investment-grade bonds
High-yield bonds vs. U.S. Treasuries

Getting into U.S. equities now, one relationship we may see deterioration in ahead of an extended correction is the "Offensive vs. Defensive Sectors" ratio, which has been leading to the upside in 2018. 

Offensive vs. defensive sectors

Other inter-market relationships that we use to measure risk appetite include the Dow Jones Industrial Average vs. the Dow Jones Utility Average, S&P High Beta vs. Low Volatility, and Consumer Discretionary vs. Consumer Staples ratios. All three of these saw some deterioration throughout 2018, breaking significant support levels several months ago, and now they have all reversed sharply higher to reclaim support. Bulls want to see this short-term improvement continue into the intermediate term, with all these ratios making new highs at some point. 

Dow Jones Industrials vs. Utilities
S&P High Beta vs. Low Volatility
Consumer discretionary vs. consumer staples

Getting into the Russell 3000 on the daily chart, we finally got an upside breakout from its year-to-date range with momentum getting into overbought conditions. This is not bearish behavior, but what would be bearish is a reversal to the downside and closing back below the January highs, confirming a failed breakout.

Russell 3000 daily

So what could drive that reversal? Well, many are pointing to the potential bearish divergence in breadth. The Russell 3000 has made new all-time highs, yet we've seen fewer stocks in the index making new highs.

Russell 3000 at 52-week highs

We're also seeing fewer stocks with momentum in a bullish range (we define this as a 14-Day relative strength index [RSI] greater than 70).

Russell 3000 with RSI above 70

What's important to recognize here is that these measures do not account for the sector rotation we're seeing under the surface. While some leaders rest, we're seeing new leadership emerge that might not yet be at new highs given its underperformance versus the index. With that said, if prices do reverse and we've not yet seen these breadth indicators make new highs, these divergences would be confirmed and warrant our attention.

We're seeing similar action in the Nasdaq Composite and S&P 500. Yes, there are potential divergences in breadth, but until it's confirmed by prices breaking their former highs, then the information remains informational, not actionable.

Nasdaq Composite Index
S&P 500 Index

Another potential red flag is the Dow Jones Transportation Average, which is back at the January highs. However, momentum barely made it back into overbought conditions. This potential divergence from a leading sector would be confirmed with prices closing back below support at 11,115.

Dow Jones Transportation Average

We're seeing a similar divergence in the leading Aerospace & Defense sector, which made new highs but has stalled, and momentum has failed to reach overbought conditions.

Aerospace & Defense ETF

Last on our list is the lack of participation from the broad-based Financials ETF (XLF), which remains range bound. This is an important part of the market, representing roughly 14% of the S&P 500, and a lack of leadership from this group remains a concern. While a consolidation through time is not inherently bearish, a resolution to the downside and momentum remaining in a bearish range would be.

Financial Sector ETF

U.S. broker-dealers have been the outperformers in this group, so a move lower from its year-to-date range would likely have bearish implications for financials overall.

U.S. Broker-Dealers

I'm sure there are other relationships like the declining performance of the semiconductor index relative to the Nasdaq and S&P 500 that are important and considered during our process, but I wanted to keep this post as brief as possible. Hopefully it has provided some insight into our thought process and the specific developments we’'e looking for in the current market environment that would change our bullish thesis.

In a falling stock market, we'll likely see some or all of the conditions discussed above occurring. With that said, it's unlikely that they all turn at once, so we'll see the shift in the weight of the evidence one chart and one data point at a time as we monitor and re-evaluate our thesis each day.

Thanks for reading, and let us know your thoughts!

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