Fresk: Don't Ignore Market Storm Clouds

May 20, 2014

What bearishness lurks in a spring that's featured a faltering rally in stocks?

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Clayton Fresk, CFA, portfolio management analyst at Georgia-based Stadion Money Management.

Since the end of February, we've seen rangebound trends form in various broad markets.

While several economic variables have been thrown into the mix, including strong employment data and continued Federal Reserve tapering of quantitative easing, various indexes have more or less shrugged the stronger data off, creating a sideways market for investors.

So, after last year's sharp 32 percent run-up in the S&P 500 Index, where do we go from here?

We feel a number of variables, including underperformance of crucial segments of the market, such as small-caps, might be telling us a pullback is coming up soon.

But first, let's take more careful measure of what's been going on.

US Equities

Outside of slight volatility in early April, the S&P 500 ETF (SPY | A-97) has traded in a narrow $3 band between $185-188 a share. This sideways price action has come with lower trading volumes, particularly over the past month or so.

While the broad index has not allowed for much in terms of price appreciation, there has been significant dispersion in sector performance, with an almost 14 percent dispersion between the top- and bottom-performing sectors (from end of February through May 9).

Sector Total Return
Telecommunication Services 10.87%
Energy 7.19%
Consumer Staples 5.49%
Utilities 5.12%
Industrials 2.51%
Materials 2.20%
Financials 0.56%
Information Technology 0.69%
Health Care -1.79%
Consumer Discretionary -4.24%

A constant rotation in these outperforming (or underperforming) sectors can have the effect of buoying the market as a whole at constant levels despite the churning and flowing of performance underneath.

Being on the right side of the rotation can prove beneficial and lead to strong performance. But being on the wrong side of this trade can cause a major drag in an otherwise-flat market.

While large-caps have been buoyed, the same cannot be said for their small-cap counterparts. Using the iShares Russell 2000 ETF (IWM | A-83), we've seen a steady underperformance in small-caps, nearly 7.5 percentage points since the end of February.

When small-caps are trailing, we interpret this as a bearish indicator, suggesting the market isn't in a speculative mode. Instead, it's flocking toward large-caps as a flight-to-quality tactic. We've never entered a bear market without first seeing small-caps underperform, so the underperformance of small caps may be a point of caution in terms of market health.

We use various measures to determine the underlying participation in a market move, including market breadth. Lately we've seen a strong negative divergence in these readings, indicating there are fewer market constituents buoying the current sideways move.

As breadth is measured against on all stocks equally, the advent of equal-weighted ETFs provides a measurement tool for evaluating market health against cap-weighted counterparts.

When equal-weighted ETFs are trailing, it is an indication the larger names—rather than the group as a whole—are driving performance. Stadion interprets this as a negative sign of market health.

As a reference, here are several snapshots of broad equal- and nonequal-weighted ETFs since Feb. 28:

 

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