Leuthold Group - From August 2015

The Leuthold Group—August 2015 3 http://leuth.us/stock-market FURTHER DISTRIBUTION OF INFORMATION CONTAINED IN THIS REPORT IS PROHIBITED WITHOUT PRIOR PERMISSION.

On High Alert

Major Trend Index Holds Just Above Negative Zone For the first time in two years, the MTI’s Attitudinal category moved into positive territory at the end of July. Both the June and July Green Books pointed out that, in the past, the same development coincided with several important short and intermediate-term stock market lows. Too Many Highs, Too Many Lows The High/Low Logic Index, developed by market analyst Norman Fosback in the 1970s, provides one way to assess whether internal market disparities have become dangerously extreme. Valuation Gap In Chinese Equity Market A-shares are overvalued relative to Chinese companies listed in Hong Kong and the U.S. These overseas issues are still the better bet for investors bullish on China’s long-term outlook.

August is “National Eye Exam Month,” but this is the rare year we can confidently recommend that you skip it. Warnings of stock market trouble have become clearer to see without thick lenses or squinting. We can, just barely, make out the “big E” at the top of the eye chart, and suspect it means to “Exit.” We made another move in that direction in late July, cutting net equity exposure in tactical funds to 48%, from 55% in early July, and down from 61% six weeks ago. The Major Trend Index (MTI), along with related disciplines we look to for substantiation and reinforcement, are on the brink of negative signals. The table has already been set. Stock market valua-tions have been dangerous for at least a couple of years, and the Fed is slowly pulling away from its reckless experimentation—a good thing in the long term, but not for stocks in the intermediate term. Current stock market breadth, leadership, and momentum are all characteristic of a very late stage bull market. The smallest amount of additional “confirmation” will send us to an even more defensive pos-ture—but we recognize the hazards of waiting for too much evidence to fall into place.

• If the seasonal pattern of the past quarter century holds sway, that bearish signal should ar-rive this month. Yet another year we’ll have to miss out on the Hamptons…

INSIDE THE STOCK MARKET ...trends, cross-currents, and outlook

Prepared by: Doug Ramsey, unless otherwise noted

http://leuth.us/stock-market

MSCI World Index:Average Monthy Performance, 1988 To Date

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© 2015 The Leuthold Group


Stock Market Observations

The U.S. stock market has largely shrugged off the latest round of worries related to China’s stock market collapse, the new down-leg in crude oil, a more hawkish tone in Fed-speak, and sizable second-quarter declines in S&P 500 sales and earnings. Investors have had a more difficult time shrugging off those concerns, however. For the first time in two years, the MTI’s Attitudinal category moved into positive territory at the end of July. Both the June and July Green Books pointed out that, in the past, the same development coincided with several important short and intermediate-term stock mar-ket lows. Should contrarians gear up for a late summer rally? We don’t think so. The improvement in sentiment is encouraging, but not sufficient to trump the deterioration seen elsewhere in the MTI and related stock market tools. In particular, our market action work (i.e., the Momentum/Breadth/Divergence category) has sunk to its lowest level since the imme-diate aftermath of the severe 2011 market decline. For what seems like forever, we’ve been willing to downplay legitimate overval-uation concerns by explaining that, techni-cally, valuations could become even more inflated, so long as the stock market contin-ued to be “in gear.” (Or “uniform,” “egalitarian,” “cohesive” or other jargon meant to provide some variation on a trend that obviously outlived our vocabulary.) But, we can’t make that argument any longer. For what seems like forever, we’ve published the accompanying chart—we even devised a simple “Red Flag Indicator” around it a few months ago. The bulls point out that “not all of the red flags are flying.” However, while the Russell 2000 and S&P Financials did not confirm the May 21st high in the S&P 500, both have subsequently rec-orded new cycle highs. The broader picture (look at the chart from an arm’s length) is now clearly one of “fracturing” (or “divergence,” “distribution,” “bifurcation”). Fortunately, the market topping process is now so advanced that our readers shouldn’t have to suffer through these tortured descrip-tions for much longer. The next big move in stocks should be down. Consequently, we’re significantly more defensive than two months ago (48% net equity exposure versus 61% six weeks ago), and we expect to get more so as our disciplines allow.

May 21, 2015latest S&P 500 bull market high

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Dow Jones Utilities


S&P 500 Financials

NYSE Advance/Decline Line

Dow Jones 65Composite

S&P 500 CyclicalSector Index*

*Equal-weighted composite of Consumer Discretionary, Industrials & Materials sectors.


Weakening Foundation

Over the last few months, we’ve presented a couple of simple quantitative studies meant to en-capsulate the factors driving our Major Trend Index to the brink of bear territory. The chart and table might provide the best summary yet. • Leadership (Dow Jones Transportation and Utility Averages), breadth (NYSE Weekly Advance/

Decline Line), and corporate credit (DJ Corporate Bond Index) have all staged intermediate-term breakdowns by falling below their respective 40-week moving averages. But the S&P 500 has, through early August, remained impervious to this underlying trouble, holding above its own 40-week average and within 1-2% of a new cyclical high.

• The bull market has ground on for so long that it’s tempting to ignore these internal warn-

ings. After all, the chart shows several intermittent periods of weakness in Transports, Utilities, NYSE breadth and/or corporate bonds since the 2009 low. But the past six weeks represent the first period since 2008-2009 that all four series have simultaneously been in 40-week downtrends. The accompanying performance table shows that average S&P 500 annualized returns have been about zero under identical scenarios… but those “average returns” include significant pieces of the 1990, 2000-2002, and 2007-2009 bear markets.

All series shown with their 40-week moving averages. 2007 2008 2009 2010 2011 2012 2013 2014 2015

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Transports, Utilities, NYSE Breadth & Bondsabove 40-wk moving avg.Three of four seriesabove 40-wk movingaverageTwo of four seriesabove 40-wk movingaverageOne of four seriesabove 40-wk movingaverageNone of four seriesabove 40-wk moving averageResults for period April 1941 to date.

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S&P 500, 400 & 600:Equal/Cap-Wtd RS Ratios




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Fed Watching For The 21st Century

We’ve become a bit self-conscious about the extent to which “market action” analysis has grown to be a larger share of our commentary in the last few years (Charts 1, 2). But, such analysis is a critical piece of our broader allocation work—and one that (we think) grows in importance during the later innings of a bull market, when even sell-side market strategists are struggling to make a valuation case for stocks. Measures conventionally dis-missed/dissed as purely technical, in fact, help us gauge the liquidity backdrop for stocks. For in-stance, in light of the preponderance of NYSE-listed issues that are interest rate sensitive, we’ve argued for years that analysis of market breadth is simply an alternative (or perhaps complemen-tary) approach to the more gentlemanly pursuit of Fed watching. The Fed’s “creativity” during the post-2008 period has been lauded, but it has under-mined several fundamental relationships we once considered reliable. (We wrote an “Of Special Interest” piece on this topic in 2011 that’s over-due for an update.) For example, the rate of change in short-term interest rates “explodes” when rates are at zero. This is a stock market in-dicator first proposed at least a hundred years ago. Quantitative Easing compromised the once-revered message of the money supply measures, and a few years back, the Fed ex-punged a large set of valuable bank reserve data in a manner that would make Lois Lerner blush. These developments have increasingly forced us to monitor Fed policy in a sort of “second deriva-tive” fashion—i.e., by monitoring movements in the asset markets themselves. The sudden struggle of equal-weighted stock market indexes might well reflect the im-pact of tightening that’s either already occurred (the lagged impact of seven QE tapering moves), or that is still to come. Several of these equal-weighted indexes have gone into relative strength free-falls over the past six weeks (Chart 3), and the Guggenheim Russell 2000 Equal Weight ETF (EWRS) has already suffered an “official,” CNBC-approved correction of –10% into its July 27th low. In sum, deteriorating stock market breadth and worrisome leadership trends both suggest liquidity has already tightened; wheth-er the Fed follows suit in September may now be just a formality.

Chart 1

Chart 2


Too Many Highs, Too Many Lows

We’ve detailed the growing degree of stock market bifurcation, but the problem for would-be bears is that such bifurcation can reach astonishing levels (witness 1999-2000) before the market is set to peak out. The High/Low Logic Index, developed by market analyst Norman Fosback in the 1970s, provides one way to assess whether internal market disparities have become dangerously extreme. The weekly NYSE High/Low Logic Index is calculated as the lesser of: (1) new 52-week highs as a percentage of NYSE issues traded; or (2) new 52-week lows as a percentage of NYSE issues traded. For analytical pur-poses, the figure is generally smoothed with a short- to interme-diate-term moving average (we use 10 weeks). High readings indi-cate simultaneously large numbers of stocks making highs and lows, indicating a dangerously high de-gree of internal divergence. The High/Low Logic In-dex entered 2015 at a maximum bearish reading above 5% (Chart 1), and following a four-month respite, has again spiked into this danger zone. We recognize that the indicator issued a set of failed signals in the second half of 2013, but today’s bear signal occurs with a broader array of supporting bearish evidence than two years ago. The bifurcation within the NYSE might come as no surprise, given its extreme underperfor-mance versus the NASDAQ mar-ket in the last year. But the High/Low Logic Index for NASDAQ (Chart 2) shows a similar level of discord; its 10-week moving aver-age has just entered the bearish zone. Note that similar readings appeared immediately before the market collapses of 2000-2002 and 2007-2009, and did not expe-rience the bothersome false sig-nals issued by the NYSE version of the indicator.

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NYSE High/Low Logic Index*(10-Wk. Avg.)

Below 1% - Tape is "in gear"- BULLISH

Above 5% - Tape is "divergent"- BEARISH

*Index calculated as the lesser of NYSE Weekly New Highs and New Lows as a percentage of issues traded.

falsesignals

NYSE new52-week highs

and lows are both at elevated levels,

a sign the stock market has

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Below 1.5% - Tape is in gear - BULLISH

Above 6% -Tape is divergent = BEARISH

*Index calculated as the lesser of NASDAQ Weekly New Highs and New Lows as a percentage of issues traded.

NASDAQ High/Low Logic Index*(10-Wk. Avg.)

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Chart 2


Minding The Gaps

We think stock market action in the next few months will provide the Fed with an excuse to skip any rate increase in 2015. But our view is a minority one, and futures’ market odds on a Sep-tember increase shot up in early August. Either way, the obsession over the timing of a Fed rate hike ignores the fact that world P/E ratios are already contracting—at least on the basis of our 5-Year Nor-malized EPS. • Normalized P/E ratios

for both the U.S. and foreign Developed markets peaked in June 2014, and the latter is down signifi-cantly (16.9x in July, down from a peak of 19.5x). Emerging Mar-ket Normalized P/E ratios are flirting with their 2001 and 2011 lows. But the declines have done nothing to close the U.S./foreign valuation gaps.

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MSCI USA Index

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Normalized P/E Ratios: U.S. Vs. Rest Of World

11.2x(Emerging Markets)© 2015 The Leuthold Group

ForeignValuation Gaps Are

Still Gaping...


Emerging Markets: A Half-Off Sale!

The Chinese government’s repeated stock market intervention attempts over the past several weeks have been remarkable, and obviously antithetical to the country’s move toward a more laissez faire corporate environment. But—with the Shanghai Composite still up 66% (Chart 1) in the last 12 months—are artificial supports even necessary? …It’s akin to keeping interest rates at zero during the seventh year of a bull market and economic expansion. The July swoon drove Emerging Market equities down to relative valuation levels seen only very briefly during their (admittedly short) history. The MSCI Emerging Markets Index now trades at a 5-Year Normalized P/E of 11.15x—an exact 50% discount to the same calculation for the MSCI USA Index (Chart 2). We’ll admit the valuation gap has become so wide that we’re increasingly tempted to override our EM Allocation Model (which has presciently remained bearish for the past 4 1/2 years, Chart 3). But we fear this gap might not begin to reverse until a cyclical bear market erupts; this month’s “Of Special Interest” section reinforces our long-time argument that value-based approaches are prone to stumble during the bull’s final charge.

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Chart 3

Chart 2

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now at a50% discount

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LATESTSIGNAL:

Switch intoMSCI World

Indexon February 28,

2011.


EM Allocation Model*

*Buy Emerging Markets when Total Return Ratio breaks above upper band, and remain positioned there until Ratio drops below lower band, triggering a switch into the MSCI World Index.

model "reiterated" a SELL signal in July


Chart 1

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The 30/30 Club!

The S&P 500 Energy sector’s latest plunge puts it down by almost a third in the last 14 months, placing it among the worst “isolated” sector declines in recent history (Chart 1). In January, we noted Energy had already suffered a 20% loss outside of a broader cyclical bear market; there have been only 19 other instances of such “stand-alone” sector bear markets since 1990. But Energy now belongs to the considerably more exclusive list of sectors which have declined 30% on both an absolute basis and relative to the S&P 500—yes, the “30/30” Club! With only three prior cases to consider (Charts 2-4), we shouldn’t draw generalizations. But we can’t help it: Note that when these other stand-alone sector declines came to an end, either a broad market correction (1994) or bear market (2000-2002) was on the im-mediate horizon. The message may be that when liquidity is no longer sufficient enough to float all of the sector “boats,” trouble may soon be on the way. Again, there’s not enough history to say. With Energy groups still rank-ing near the bottom of our GS frame-work (Refiners are the exception), is it time to worry about Energy joining the 40/40 Club (40% decline/40% un-derperformance)? Only the Consumer Staples sector has achieved that status (appropriately enough, during the peak of baseball’s steroids era from 1998 to 2000).

Chart 2 Chart 3

Chart 4


Table 1

The 30/30 Club (continued)

Is a severe, isolated sector decline like Energy’s apt to be followed by outperformance? Based on our tiny sample, the answer is yes. • As shown in Table 1, Health Care, Staples, and Materials sectors all reversed their “30/30” un-

derperformance during the subsequent two years, beating the S&P 500 by an average margin of +47.6%.

Chart 5

Sector Dates

Consumer Staples November 23, 1998 - March 14, 2000 -40.8 % -55.1 % 16.3 % 57.7 % 67.7 %

Energy June 23, 2014 - August 4, 2015 -32.8 -39.4

Health Care January 9, 1992 - August 12, 1993 -38.6 -46.1 9.4 16.1 37.9

Materials May 6, 1999 - March 7, 2000 -30.0 -31.8 -11.3 23.1 37.3

Average -35.5 % -43.1 % 4.8 % 32.3 % 47.6 %

*Cyclical Bear Markets in the S&P 500:July 16, 1990 - October 11, 1990July 17, 1998 - August 31, 1998March 24, 2000 - October 9, 2002October 9, 2007 - March 9, 2009April 29, 2011 - October 3, 2011


The 30/30 Club:S&P 500 Sectors To Have Declined 30% On Both An Absolute And Relative Basis

Outside Of A Cyclical Bear MarketRelative

Perf.Next

24 Mos.

RelativePerf.Next

12 Mos.

RelativePerf.Next

6 Mos.DeclinePct

S&P 500Rel to

DeclinePct

After the decline ended,forward sector relative returns from

this tiny sample were excellent.

• With our focus (and, for that matter, most everyone’s) on the S&P 500 lately, we nearly overlooked some of the incredible stats being put up these days in the minor leagues. Think the 30/30 Club is a big deal? There’s a Small Cap sector that’s just joined the 60/60 Club! Yes, the S&P SmallCap 600 Energy sector had declined 64.0% into its August 4th low (Chart 5), underperforming the S&P Small-Cap 600 by –67.8% since June 30, 2014.

• Again, Energy groups (save for the Refiners)

rate poorly in our Group Selection (GS) model, and we don’t have a separate frame-work to handle the Small Cap groups. But this chart finally smacks of capitulation…

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2000S&P SmallCap 600Energy Sector

-64.0%(August 4th)© 2015 The Leuthold Group


Avoiding Gold

The vast majority of recent gold commentary centers on its extremely oversold technical condi-tion and the related washout in all sorts of sentiment indicators, ranging from trader surveys to futures and options positioning. Maybe these conditions will produce a short-term bounce, but we’re going to stand with the message of our bearish longer-term work. “Oversold” is in the eye of the beholder. Gold’s four-year decline of around 40% does not look all that cathartic on a monthly chart, especially one that’s logarithmically scaled like the accompanying Chart 1. Bullion would need to drop another 40% to reach its median long-term ratio versus the Consumer Price Index. And the ratio’s many years of levitation above its median raises the odds of an overshoot, when and if that median is crossed. (We’ve expressed the same concern over crude oil, which—for all the carnage its collapse has triggered—has merely returned to an average level on a CPI-adjusted basis.) Gold’s action has historically been a pretty good harbinger of near-term price trends for industrial commodities, although the relationship has weakened since the onset of the Great Recession. Historically, the 12-month rate of change in gold has led the 12-month rate of change in the CRB Raw Industrials by about six months (Chart 2). Based on that trend, gold’s 12-month decline of 15% suggests further near term weakness in the CRB (even though the latter also looks oversold in price and washed out on the basis of most sentiment measures).

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Chart 2

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$693Implied targetif the

Gold/CPI Ratio falls to its 1970-

to-date median.

Leuthold Group - From August 2015

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