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2/4/2011 - US Leading the Way...but where?


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Equity Market Overview
The most remarkable aspect of recent equity market action is its resiliency in the face of continually weakening market internals. The equity market's internal strength, as measured by the number of New Highs, peaked way back in October. Yet, with each successive push higher in prices, the number of New Highs continues to diminish.

My concern is that any healthy advance in prices should be met with a broad-based advance in most stocks rather than a shrinking contingent of leaders. In other words, each successively higher price peak should be met with as many or more stocks reaching new highs. Such a narrowing in leadership is generally not a sign of strength.

A standout in this dichotomy is the S&P 600 Small Cap Index. The contraction of New Highs is the most severe in this group and portends significantly elevated risks. Conversely, the contraction of New Highs is least apparent in the S&P 100 which is comprised of only the largest behemoth stocks. Thus, we see institutional smart money moving towards the liquidity and comparative safety afforded by large capitalization stocks while shunning volatile and risky small-caps. This is textbook defensive behavior by smart money as they prepare for potential downside.

A related observation is the abysmal performance of international equities in general and, in particular, those areas that had been last year's leading international countries. This theme echoes what we are witnessing in the domestic market where smart money is retrenching from higher risk markets in favor of safer havens.

Weekly sentiment surveys from AAII and Investors Intelligence continue to show a persistence of high bullish sentiment (optimism). In the past few years, such high levels of optimism have either led to intermediate-term declines or extended sideways consolidations.

An intermediate-term market top is formed when a combination of high bullish sentiment, as exists today, coincides with poor market internals. At present I would categorize market internals as poor. The present environment seems to suggest that the internal market weakness may soon be met with more obvious price declines.

However, longer term analysis of market internals is not nearly so ominous. The Advance-Decline Line has earned its keep over many decades due to its ability to signal the end of many bull market advances (most recently again in 2008). At present, the A-D Lines of all major market sectors (large, mid and small-cap) continue higher unabated. This, at the very least, augurs well for the continuation of the uptrend in spite of what might amount to some white-knuckled declines in this first quarter.


 

US Equity Markets (Equity Style Model)
 As I mentioned in the Overview, Small-Capitalization stocks appear most vulnerable. In fact, the relative performance of the Small-Cap Growth segment has already faltered badly going into the start of the year showing the change in leadership and growing aversion to risk.

Large-Cap Value stocks represent the polar opposite of Small-Cap Growth stocks. Not surprisingly, we are beginning to see Large-cap Value outperform most other style boxes. This also illustrates defensive behavior on the part of smart money as large-cap value is historically a safe haven during market weakness.


 

International Equities
As noted in the Overview, the weakness in higher risk overseas markets suggests a retrenchment by investors in favor of safer havens. Interestingly, nearly the same thing occurred this same time last year. The relative weakness of foreign, and higher risk, markets then hinted at a broad equity market consolidation. Perhaps this recent weakness is a similar omen.


 

Investment Grade Bonds
We are long International investment Grade Bonds. The renewed weakness in the US Dollar (and commensurate strength in foreign currencies) provides a nice tail wind to our position. Domestic bonds are not fairing nearly as well though I suspect the world's bond markets will all see strength in the short-term. Sentiment has reached bearish extremes and signals a bottom in prices.


 

High Yield Bonds
High Yield Bonds are likely to reflect general equity trends in the coming weeks and months and have to be viewed as higher risk at present.


 

Real Assets / Inflation Hedges
Our models are long Commodities and REITs. The strength in Commodities usurped Gold Bullion as the latter experienced a shallow correction. The long-term uptrend in Gold Bullion is still intact, however, and I won't be surprised is the models, once again, look to Gold in the coming months. I don't have as much hope for REITs if the equity market runs into trouble.


 

Currencies
We are long the Canadian Dollar (60%) and US Dollar (40%).

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