The Move Toward 'Safety' Continues

This is a brief update on the technical backdrop in the US stock market. In spite of the recent rebound, the move from 'growth' to safety has continued. We use the XLU-QQQ ratio to follow this trend, but one could e.g. also employ consumer staples instead of the XLU and would see the same trend. This week we will get more 'tapering' from the Fed as well as the payrolls data, both events that could be short term triggers for the next short term move in stocks.

A noteworthy detail is that the market was weak on Friday. Weakness on Fridays indicates growing uncertainty (traders don't want to remain long over the weekend). In this particular case it was widely reported that the continuing trouble in the eastern Ukraine triggered market weakness, but no-one actually knows what would have happened in the absence of such news. Trouble in the Ukraine is not exactly 'new' news after all. It's been going on for months.

The XLU-QQQ ratio's uptrend that started earlier this year is unbroken – click to enlarge.

We would actually be inclined to call the chart above something like 'so much for the theory that QE tapering doesn't matter'. It is probably no coincidence that the ratio has begun to climb precisely at the time when 'tapering' by the Fed started. Once again, no matter what they say, the fact remains that tapering of QE amounts to a tightening of policy, since money supply growth is slowing down as a result.

Divergences Revisited

Below is an update of our 'index divergences' chart. The decline on Friday has produced yet another divergence: this time the Russell diverged from the other indexes by turning down from a lower interim high. Since relative strength in the Russell was a hallmark of the bull market, a show of relative weakness is unlikely to be a good thing (one must keep in mind that this divergence could be quickly erased again, but for now it exists):

NDX, SPX, RUT and DJIA – a series of divergences – click to enlarge.

Sentiment

Little has changed on the sentiment front – negative divergences between surveys such as NAAIM, Market Vane, Consensus Inc. and Investor's Intelligence and the indexes have been recorded, but the Rydex fund family and money market funds continue to exhibit unbroken optimism of the sort that has rarely been encountered historically ('rarely' in case of the former means exactly once: in early 2000).

Rydex fund data continue to show unbroken near-record optimism – click to enlarge.

The divergence between survey data and the indexes is illustrated by the NAAIM data depicted below. The peak in net long exposure according to the NAAIM survey was attained in January, well before the peak in SPX, Nasdaq and Russell:

The NAAIM survey of fund managers (replies regarding exposure can range from 200% short to 200% long) vs. the SPX. Intensity measures the dispersion of the responses. At the peak not a single survey respondent was net short – click to enlarge.

Another interesting datum which we haven't discussed before is the percentage of total market capitalization the amount of money parked in retail money market funds represents. Note that this has nothing to do with the much discussed 'money on the sidelines' meme, which is a nonsensical concept (the supply of money changes on account of central bank and commercial bank activity, it is not influenced by trading on the stock exchange. Money does not 'flow into' or 'out of' stocks, since every trade involves both a buyer and a seller).

Rather, what this ratio represents is another measure of sentiment. When the secular bull market started in 1982, the ratio reached a high point. Today it is at its lowest point in 35 years. Obviously this is not an indicator relevant to short term timing – it is however likely to have long term significance.

Retail money market fund assets vs. the stock market's total market capitalization – click to enlarge.

Lastly, with respect to economic and market confidence, there is another indicator that may be worth watching: the so-called 'US economic policy uncertainty index'. This indicator is constructed from the number of tax provisions set to expire, the variance in forecasts by professional economists, and a search for key words in the news with respect to discussions of economic uncertainty.

While this is clearly also a contrary indicator, it can remain at very low levels for extended periods of time. In all likelihood though it is also useful as a signal when it diverges from other indicators, such as the level of stock market indexes, high yield bond spreads, etc.

Recently the 'policy uncertainty' index for the US has declined to a new multi-year low, in fact a level last seen in 2007. This is mainly interesting because 2007 was not exactly a propitious time for buying stocks.

US economic policy uncertainty has declined to a new multi-year low in April – click to enlarge.

A Leading Fantasy Stock Craters

Lastly we want to take a brief look at the stock of Amazon (AMZN), which is one of the market's 'fantasy' stocks. This is a term we use for the stocks of companies that have either no earnings at all, or very little earnings relative to their market cap, and which are driven either by imagination alone or some metric unrelated to earnings (e.g. 'eyeballs', the metric Facebook recently employed when shelling out $19 bn. for WhatsApp, or revenue growth, which is relevant in Amazon's case).

The theory on which AMZN's bull run was based went as follows: “The company has already shown it can post large profits whenever it wants to. It is more important for it to rule internet commerce by increasing revenue and obtaining a greater share of the money spent in online purchases, even if that involves not making any money in the near term.”

This is actually not an entirely unreasonable argument, but it is clear that there is a certain danger that things may not work out as planned. One question people must ask is e.g. what is going to drive the stock's price when the strategy finally comes to fruition, as that will probably go hand in hand with a slowdown in revenue growth (as revenue growth is currently acquired at the cost of profitability). However, AMZN seems to have run into a different problem lately: faith in the 'making it all up with volume' idea seems to be faltering.

This would normally not be worth talking about, if not for the fact that a great many momentum stocks are 'fantasy stocks' in one way or another, and AMZN has up until recently been a leading one. Its relative strength has been in sharp decline since January. Since it has been leading the bull market, the question is: what is it leading now? Note though that a short term volume climax may have occurred on Friday:

AMZN and the AMZN-NDX ratio – an undisputed upside leader until January 2014, and leading to the downside ever since – click to enlarge.

It is of course always possible that some other stock 'takes the baton' from AMZN, but nearly all momentum stocks were extremely stretched to the upside earlier this year and have become prone to weakness of late. Investors  would do well to consider the possibility that AMZN's new trend could be yet another early warning indicator of an impending larger-scale trend change.

Conclusion:

Continued 'tapering' of 'QE' is going to have a sizable effect on US money supply growth, which in turn has been the major driver of the rally in the stock market. The new policy is implemented just as nearly every positioning and sentiment measure is close to record highs. Risk remains very high.

Charts by: stockcharts, sentimentrader, St. Louis Fed