Peak in S&P 500 Obscures Signs of Weakness
Slump in small caps, shrinking new highs raise concerns, says market maven Mendelson.
Thirty years ago, President Ronald Reagan declared it was "Morning in America," and the U.S. electorate apparently agreed, reelecting the Gipper in a landslide that November.
The stock market today is casting its ballot in the opposite direction. Even as the Standard & Poor's 500 peeked above the 1900 mark for the first time Tuesday, the Russell 2000 continued to droop, dropping 1%.
The difference between the indices represents more than size, with the former being the benchmark of large-cap stocks and the latter the small-cap gauge. The U.S.-domiciled companies in the S&P 500 actually are international businesses, with nearly half of their revenues coming from abroad. The Russell 2000, by contrast, is nearly All-American in its revenues and earnings. Their divergent performances suggests not all is well in the U.S. of A.
From a technical standpoint, the Russell 2000 has been the major index posing the greatest intermediate-to-long-term risk, according to John Mendelson, one of the deans of technical analysis, of International Strategy & Investment Group. (That view also has been shared by Barrons.com's Michael Kahn in his Getting Technical column and was noted in Ben Levinsohn's Stocks to Watch blog Tuesday.)
Mendelson notes in his weekly ISI report the Russell 2000 was the first major average to decline to its 200-day moving average, a sign of waning momentum. Moreover, volume has been lighter on up days and heavier on down days. He looks for support around 1050, its October 2013 low, and about 6% below Tuesday's call.
What's ironic, he continues, is that ISI's clients express more concern about emerging markets. But it's the domestic Russell 2000 that is leading the market's decline so far, he adds..
At the same time, Mendelson also observes widespread bullishness about the dollar. But the chart of the U.S. Dollar Index -- a basket of six currencies' exchange rates versus the greenback, which is dominated by the euro -- doesn't show a bullish trend. In technical terms, the Dollar Index formed a double top in mid-2013, before entering a descending trend. The chart sits at a major support at the lows first touched in the summer of 2012.
"If this was a chart of a stock, many chart readers would be concerned about the possibility of a major breakdown, but I don't hear that comment about the dollar anywhere I go," he writes.
So, Mendelson observes, both the U.S.-oriented Russell 2000 and the U.S. Dollar Index appear weak, not strong, as the consensus thinks.
As for market internals, he points to a number of other negative divergences.
While the Dow Jones Industrials and the S&P 500 posted records, the number of new highs on the New York Stock Exchange continues to contract, a trend Mendelson has noted previously.
Moreover, the relative strength of financials (based on the NYSE Financial Index relative to the S&P 500) topped out 15 months ago, in January 2013. In the previous cycle, their relative strength peaked in February 2007 -- eight months before the top in the S&P 500.
Turning to the great conundrum of 2014, the Treasury market, Mendelson concedes he was part of the "99% consensus" at the turn of the year that asserted yields had nowhere to go but up. The chart of the benchmark 10-year note now stands a crossroads formed by the downtrend line from a hair over 3% at the end of 2013 and the support line just under 2.60% touched several times in 2014, and secondary support around 2.50%.
As those lines converge, Mendelson thinks the market will provide an answer as to which way bond yields are headed. The technical maven says he'll wait for the market's answer.
(From a fundamental standpoint, a falling dollar and weaker domestic stocks would correlate with lower bond yields, but we'll see.)
But underlying his view is a single, overriding factor: the diminution of liquidity, which is the availability of ready buyers and sellers, which he says is the poorest "I have seen in over 50 years in the business."
He traces this to the "demise of NYSE specialists, the much smaller role by Block Traders, and banning of 'Prop Desks' by the Volcker Rule." This observation is echoed in the fixed-income markets, where dealers increasingly are unwilling to take positions as banks restrict capital allocated for market-making.
The result, Mendelson sagely observes, are exaggerated moves higher on good news. "This upside lack of liquidity brought smiles, not concern, because we are all human."
"Clearly," he continues, "illiquidity is a two-way street and now we are beginning to see some of this on the downside." Specifically, he points to the steep recent drops in so-called momentum stocks, citing Twitter (ticker: TWTR ), Amazon.com ( AMZN ) and biotechnology stocks as examples.
Mendelson pointedly notes that the "New York financial press" has played up the new highs in the Dow and the S&P 500 while ignoring the dissonant indicators he sees, such as the narrowing of the new-high list and the lagging performance of small caps and financials. As a card-carrying member of this cabal, I hope this effort corrects that error of omission.