End of the Bull Market in Sight?

Written By Briton Ryle

Posted March 31, 2014

After five years of stellar growth in U.S. equities, with at least 12 months of new all-time highs each and every quarter, the stock market may have finally reached its high-water mark.

Multiple signals are warning us that the tide is turning and has started heading out.

Since we haven’t had a noteworthy correction since the 18% correction of mid-2011 or even the 10% pullback of mid-2012, experts are telling us to batten down our investments and anchor our positions. The next correction to hit us could be big.

So is this it? Is the bull run over?

Not exactly. There is a strong undercurrent building up beneath the surface of the economy that is gaining more and more power, and it will ultimately lift all ships to new all-time highs next year.

But for the next several months, the tide will be flowing out. Last week alone, U.S. equity mutual fund holdings shrank by $4 billion, the largest weekly outflow since the middle of February.

What is even more alarming is where those investments are being withdrawn from — sectors that historically lead the rest of the market in a new direction.

Here are just three signals pointing to lower equity prices…

1) Small-Cap Stocks Turn

Companies with market caps below $250 million will typically lead the bullish charge uphill because they have not yet saturated their markets like the large caps have. Over the past five years since the recovery began, while the Dow Jones Industrial Average of large caps is up a hot 118%, the Russell 2000 index of small caps is up a smoking 180%.

Unfortunately, their small cash flows and high debt ratios make small caps more susceptible to corrections as they lead the bearish retreat back down when conditions worsen.

During March — the third worst month in at least the past 12 — the small-cap Russell 2000 has lost nearly 3%, while the large-cap Dow has lost less than half of a percent. Small caps are again leading the way down.

2) Momentum Stocks Slow

Momentum stocks are typically medium- and large-cap companies that have so much impetus, they perform a lot like small caps for their ability to outpace the broader market.

Where the broader S&P 500 is up a meaningful 17% over the past 12 months, momentum powerhouses have blown everyone out of the water — such as Netflix (NASDAQ: NFLX), which is up an impressive 90%, Facebook (NASDAQ: FB), which is up an enviable 140%, and Tesla Motors (NASDAQ: TSLA), which is up an outrageous 450%.

But like small caps, momentum stocks can change direction very quickly. Their exaggerated upward moves distort their stock prices to disproportionately elevated valuations, giving them much more air to fall through on their way down.

A group of 24 of the hottest momentum stocks as compiled by Credit Suisse have averaged losses of 19% in March alone compared to the broader market’s S&P 500 drop of just under 1%.

Vice president at New York’s Fusion Analytics, Joshua Brown, sees this as a warning sign. “The weakness in momentum stocks does have an implication for the broader market,” he points out. “The best way to gauge general risk appetite is to look at momentum sectors.”

Russ Koesterich, chief investment strategist at BlackRock, reiterates, “Some of the froth is coming off. There’s a little bit more risk aversion, and when risk aversion rises it breaks the momentum trade.”

So if small caps and momentum stocks are telling us that investors are becoming more risk-averse, we might expect money to begin flowing into more secure investments, such as bonds — our third major indicator of an impending reversal of the tide.

3) Bond Inflows

During the recent mini-pullback in equities in January, when the S&P fell about 6%, money flowed into 10-year Treasury notes, driving their yield down from 3.04% to 2.58% for the largest single monthly drop in over two years — a strong indication that investors are getting nervous.

Making matters worse, when equities rallied in February to fresh all-time highs by the beginning of March, they did so without money coming out of bonds. The money that went into bonds in January stayed there.

In the graph below comparing the 10-year U.S. Treasury yield (black) to the S&P 500 index (beige) and the iShares MSCI USA Momentum Factor ETF (NYSE: MTUM) (blue), we notice that during the year-end rally from late October to late December, the equity run was supported by money flowing out of bonds, as noted by all three lines rising together.

Bond Outflows (Small)Click Here to Enlarge
Source: BigCharts.com

More mirroring was seen during January’s pullback, when money flowed out of equities into bonds, as noted by all three lines falling together.

But do you notice the difference in February? While equities rallied, the 10-year stayed relatively flat. Though equities climbed to higher levels in March than in December, bond yields remained lower in March than at year’s end. The rally in stocks was not supported by money coming out of bonds.

The smart money was not persuaded in February as it had been in late 2012, and it decided to stay in bonds. February’s rally was nothing more than a hopeful rally, a bull-trap.

Does this mean the bull run is over? No. All we are seeing is an elephant climbing out of the swimming pool.

The Fed Leaves a Void

It is no coincidence that the recent jitteriness of the markets began at the start of January — just two weeks after the U.S. Federal Reserve announced it would start reducing its monthly bond purchases and terminate the program most likely by the end of 2014.

The Fed’s presence in the bond market to the tune of more than $1 trillion a year was quite noticeable, and its exit will be equally noticed. Like an elephant climbing out of a swimming pool causes the water level to fall, so too has the Fed’s reduction of its monthly bond purchases been causing bond prices to fall and yields to rise.

When U.S. 10-year Treasury yields surpassed 3% by the end of December, investors found the highest rates in over two years too attractive to resist. When the Fed started climbing out of bonds in January, investors started jumping in.

But from where would the money come? There was only one place it could come from… the red-hot equity market, which was at all-time highs. Hence, we saw January’s rotation out of equities into bonds.

Yet the Fed has reduced its monthly bond purchases two more times since then. The more the elephant steps out, the more investors rush in to fill the void, and again it all comes out of equities. We can expect this rotation out of equities into bonds to continue for the better part of this year until the Fed is completely out of the bond pool, likely by Q3.

Equities, therefore, should remain under pressure for the next six to nine months. But they shouldn’t collapse into a bear market. There is a very strong indication that the equity bull run will resume by the end of this year.

A Supportive Undercurrent

Let us think… Would the Fed really be comfortable exiting the bond market and ending stimulus if the economy were not strong enough to walk on its own? America’s GDP is getting stronger. Toddler is getting his footing, and the Fed sees it is time to pull its helping hand away.

As indicated in the graph below, U.S. annual GDP growth has been positive since the start of 2010, averaging just over 2% for the past four years.

Annual GDP growth since 2010 (small)Click Here to Enlarge
Source: TradingEconomics.com

Forecasts are calling for America’s annualized GDP growth rate to be even faster over the next four quarters, reaching 3.0%, 3.2%, 2.8%, and 2.7% respectively, and averaging 3% in 2015. (Source: Trading Economics)

It is for this very reason that the U.S. Federal Reserve is confident enough to start the economy on the long road back to rate normalization, beginning with the termination of its monthly bond-buying program before this year is out.

Turbulence Ahead

In the meantime, however, look for more money to move into Treasuries as the Fed’s exit leaves gaping holes in bond yields that investors can’t resist. As this money moves into bonds, there will be less money left over for equities.

Yet this is actually bullish for stocks, since it will give them an opportunity to cool off a little. After markets have moved sideways a few months, perhaps until the end of Q2 or early Q3, GDP will have crept up and stock valuations will have eased down to the point where the underlying economy will have built up enough momentum of its own to lift equities right back up again.

So trim your sails by trimming your profits, and anchor your holdings on solid companies that have not run up so much. Now is not the time for risk.

Until next time,

Joseph Cafariello for Wealth Daily

Angel Pub Investor Club Discord - Chat Now