Since the market peaked four months ago on June 23rd, the large cap stocks have outperformed significantly. We see it in the difference between the SP500 index (TSP C fund) and the non-SP500 index (TSP S fund). We even see it within the SP500 index with the largest 50 companies pulling the entire index up just as they did before correction.
June 23rd marked the peak of the total US stock market and the small cap indexes. The SP500 peaked on May 21st and just missed a new high in June. When the indexes retested their correction lows on 29 September, the large cap indexes held above their initial low. But the small cap indexes to include the Russell 2000 and non-SP500 index (TSP S fund) established new lows.
During the recent rally, the large cap SP500 and Dow Jones Industrial Averages established new post-correction highs while the small caps have not. As of Friday, the small cap indexes are near the top of a down channel and cannot seem to breakout to the upside. The large cap stocks appear to be parting ways with the small caps.
During the bull market, it was always the small caps that ran ahead of the large caps only to run back to the large caps during corrections. So this is not normal bull market behavior. But again, it is not really the entire SP500 that is advancing, it’s the largest companies.
Today it was Microsoft that jumped 10% in pre-hour trading on the too common occurrence of better earnings but with declining revenues. Before the correction, it was Apple and Google advancing the mega-50 index. These are great companies, but can they hold the entire market up?
The New York Stock Exchange (NYSE) lists a broad range of companies. While its rally is not as robust as the SP500, it is also trending up. But the NYSE advance-decline volume index has been lagging its price and has not advanced since the early October surge. Low volume rallies are a sign of weakness – another indication of the balancing act.
Central Bankers to the Rescue?
The central bankers are not oblivious to the situation in the financial markets and slowing global economy. The world begged the Fed not to raise interest rates in September and now we know why.
On Thursday, the European Central Bank President implied they would expand their QE in December and today China cut interest rates. The combined effect of the three central banks non-actions, announcements and actions is a global loosening of monetary policy. Is this the catalyst for the favorable season in stocks? Will this create a sustainable risk-on rally?
The bad economic news is good market news effect is back in force. With the Fed delaying, the financial markets savior every piece of weak economic reporting interpreting this as continuation of easy money policies. And for the most part they have been having a feast of late.
If the markets are diverging among themselves, they are significantly diverging from their underlying fundamentals. Can this divergence hold through an entire favorable season for equities or at least through the end of the year? Yes, but only if we see a trend reversal in risk preference.
Relief Rally or Risk-On
They say the market is driven by greed and fear. I would expand on that a bit. During bull markets we see greed (rallies) and exhaustion (pull-backs), but in bear markets you see fear (plunges) and relief (rallies). At market tops, they may look a lot alike so I think it comes down to whether the market has a preference to hold more risk or less. There is a tipping point.
A move from small caps to large caps may be part of the move to lower risk. The larger companies hold more cash and less debt typically. They can weather storms better. The one exception are the companies who engaged in significant buybacks if they compromised their balance sheets too much.
Its funny, the SP500 buyback index is underperforming the SP500 index. The companies who engaged in an activity that was designed to boost their earnings per share are being penalized by the market. Something about buying stocks when they are overvalued I assume.
I am sitting on the fence now balancing the narrow-based rally with the weak broader market, balancing the seasonal tendencies of the market with the cyclical tendencies of the market. My market risk aversion indicator is back on the fence too, balancing, and I am waiting to see which way it falls. If the risk preference trend reverses the SP500 could put in a double peak. If not this may simply be one of those violent rallies that bear markets are known for. I am watching closely.
You can join us to watch closely too.