3. ‘Technicals’ Are Faltering. Overvalued equities can become even more overvalued, particularly when authorities are easing the rate reins and/or an economy is expanding at a brisk pace. In fact, expensive stocks often become even pricier before market participants typically become squeamish. Yet current technical data show that – across the entire risk spectrum – the smarter money may be seeking safer pastures. What’s more, authorities are talking about tightening at a time when the economy is not expanding briskly.
In the bond market, the spread between the Composite Corporate Bond Rate (CCBR) and the 10-year yield is widening. That is a sign of risk aversion. Similarly, investment grade treasuries are witnessing higher highs and higher lows (bullish) whereas iShares iBoxx High Yield Corporate (HYG) has seen lower highs and lower lows (bearish). These developments are also signs of risk leaving the room before the elephant.
In equities, more stocks in the S&P 500 are below their long-term moving average (200-day) than above them. This is coming form a place where 85% of the components had been in technical uptrends. Historically speaking, this kind of narrowing in market breadth is typically associated with an eventual stock benchmark correction.
Additionally, as I had identified in my commentary one week ago, the New York Stock Exchange Advance Decline Line (A/D) has a strong track record as a leading indicator of corrections/bears. It recently crossed below its 200-day for the first time in four years (as it did prior to the euro-zone crisis in 2011). In addition, decliners have been pressuring and outpacing advancers regularly since the beginning of May.
Granted, the Dow Jones Industrials (DJI) Average and the Dow Jones Transportations (DJT) Average may not be as important as the S&P 500 in identifying technical breakdowns. (Dow Theorists would disagree with me on that.) Nevertheless, when the DJI and DJT are both signalling the potential for longer-term downtrends, there’s something going on. What’s going on? Risk is quietly tip-toeing off the stage.
I’ve been telling folks for several months to rethink partying like it’s 1999. Otherwise, you may find that you overstayed your welcome and that the punch bowl is empty.
Is it too late to ratchet down the risk? Hardly. When sky-high valuations meet with weakness in market internals, a 65% growth/35% income investor might make a strategic shift toward 50% large-cap and mid-cap equity/30% investment-grade income/20% cash. You’ve reduced equity risk by avoiding small companies; you’ve reduced income risk by exiting higher-yielding junk. And you’ve given yourself the cash that put you in the right frame of mind to be able to “buy lower” in the next correction.
Gary Gordon is president of Pacific Park Financial, Inc.