Market Internals Collapsing, Bonds Fire Warning Shot

Thursday July 22, 2010

Note, this is an overlay graph from 1987. The red black bars are the Dow Industrials, the black line is the thirty year bond price. What happened then is that bond prices sank as money poured into stocks. It was bizarre, stocks would hold back each day until bonds closed their trading at 2 PM CST, then stocks would rally again. After Labor Day in September, it was clear the rally in stocks was losing strength, but  bond prices continued falling. And then one day in October bonds had such a better interest yield than the dividends offered by stocks that each adjusted, all in one day. This became known as the crash of 1987. It was the five year anniversary of the 1982 lift off in stocks, ending the bear market since 1966.   But our point is that when bond and stock prices diverge an adjustment is finally necessary for risk pricing. 

Markets never do exactly the same thing twice, darn it, but again we have a divergence in price. This time bonds have moved up smartly while stocks are sinking. Bonds are forecasting a period of deflation and economic stagnation, why else would one year yields be under 1%?  This is the same thing that has happened in Japan, for the last twenty years!  This explains the Wall Street Journal article that Japanese have been snapping up US bonds at these yields. The Japanese are aware that yields can stay in low single digit territory for years. A three percent bond looks great compared to say a one percent bond, and so they are buying Treasuries.

Regrettably the time line of the first chart to October is not available for 2010 at this time….but this is a warning shot that stock investors are ignoring the bond rally. Low bond yields mean there is little demand for money, ie, we lack productive uses to put debt to work, hence the high unemployment numbers, price markdowns at Wal Mart, low housing starts, a nine million year for car sales equal to about 1984, and so it goes. 

The news is always looking for some fundamental event to explain the day’s market action. And so yesterday it was, Bernake sinks stocks. Well the charts tell another story, the internals of the stock market have been sinking since April 26, this was just a continuation of the pattern. What is amazing, given the internal collapse, is that the averages are as high as they are. Consider this, when the SPX broke at the first purple arrow on top, the average was above 1100. And the percent of stocks above the 200 MA was about 75. Now that same percentage stands at 44.2, yet the average has only dropped 20 or 30 points. The internals are collapsing in a  clear fashion, the purple line shows this, the action has not even touched the 50 bar MA on the way down. The rate of change at bottom reflects a big rally but all the rally did was get back to the downtrend line. Now couple this picture with the first page of stocks versus bonds. Money is draining from stocks to bonds, never mind what Bernake says is happening. It is as simple as that. At some tipping point, stocks may collapse as money exits to safer territory. Certainly  a maximum rate of change spike shown at bottom has not turned momentum around.

 The Summation Index is even more of an early warning indicator. Note that it peaked last October, 2009!.  The rally to new highs in the NYSE at top (the symbol is NYA) saw a lower high in the summation index, a negative divergence, fewer stocks in fact participated. And so the summation index and the MACD of it led the stock average lower. Now the internals of the market have collapsed, percent wise, much much more than the actual index, just as in SPAX200 above. MACD has rallied back on these up and down days we have had lately. As I write at the pre market opening for July 22, stocks are up, but the internals are nowhere near the price of the index to justify some sort of bull market stance.

Bottom line, this is an extremely dangerous market. The internals are falling apart as investors exit stocks. The weighted average price indices do not reflect this divergence but these last two charts show just that. Couple the stampede for the exits in stocks with the bond rally and we have a very, very  dangerous environment.  Extreme caution is warranted.