The Most Speculative Sectors Are Going Wild
Yours truly remembers late 1999/early 2000 well. It was a time that could be best described as 'waiting for the tech crash'. One of the most striking features of the final blow-off surge of the tech mania was its sheer size (the final legs up in the 1920's bubble and the Nikkei bubble of the 1980s were far more subdued by comparison). However, what was even more fascinating was how thoroughly caution was thrown out of the window. Completely worthless paper started to rise, just as long as it could be argued that it had remotely to do with technology. The stories became ever more fantastic as time went on ('superconductor stocks', 'space stocks', you name it). The action finally moved into OTC BB listed and pink sheet stocks, the 'micro-cap' names, most of which no-one had ever heard before. Day traders (a large population at the time) took notice and began to scour the charts of these stocks for 'pretty looking' formations that may result in break-out moves. And rightly so, since many such moves did in fact happen, even if the underlying companies had never produced a red cent in earnings or revenues, and had no realistic hope of ever doing so. These days one no longer needs to expose oneself to the 'company specific risk' of micro-caps. Today there is an ETF for everything. Guess which one has just 'gone vertical'.
Of course one must admit that the action these days is different from the full-blown mania of 2000, which was a near perfect reenactment of 1929 in terms of surging public participation and wildly bullish sentiment. Nowadays, even with the indexes at new highs, there is an undertone to the proceedings that feels different. The public is no longer mesmerized by stocks and the get-rich-quick mentality has definitely expired. These days it is mostly professionals bidding stocks up in the hope of greater fools letting them out 'when the time comes' (if all of them realize in real time when that dreaded day arrives, the market will of course go 'no bid'). All in all, it feels more 1937nish than 1929nish.
The micro-caps are accompanied in their manic surge by small cap indexes like the Russell 2000. Usually, outperformance by the Russell 2000 index is considered bullish, and most of the time rightly so. But one must not lose sight of the fact that when such outperformance becomes extreme, it can also constitute a warning sign (just as the normally bullish outperformance of the Nasdaq index constituted one in early 2000).
One reason to continue to look a bit askance at this extremely strong performance is the fact that speculators in stock index futures hold their by far greatest net long exposure in precisely this riskiest market sector. In the large and mini Russell contracts combined, this exposure has grown to a record value of $27 billion, by far the largest of any stock index futures contract.
A chart of the commitments of traders in Russell 2000 futures (big contract). The value of the total net speculative long position in large and mini Russell 2000 futures combined has reached a new record high of nearly $27 billion – click to enlarge.
Sentiment surveys generally show an amount of giddiness appropriate to the price action, but what may be more important than this fact is that there exist now both short and long term divergences with prices.
First a look at a short term divergence, between the AAII bull-bear ratio and the S&P 500 Index:
A longer term sentiment divergence can be (inter alia) seen in the Market Vane bullish consensus. Here we compare the 2007 situation to today's:
More Technical Divergences
When looking at the SPX, we were struck by two facts: for one thing, there is now a price/momentum divergence in place as a result of the recent brief correction. What may be more important though is that there is a divergence between the SPX and the strongest stock index in Europe, Germany's DAX. Of course all these divergences may still be erased, but they certainly are a 'heads up' one would do well not to ignore.
S&P 500 Index: momentum divergences and a divergence with the DAX index (the green line below volume) – click to enlarge.
Of course, none of this may matter – as our friend B.C. reminded us today, the SPX and the monetary base continue to track each other very closely, and as we all know, the monetary base is set to continue to rise for months to come.
However, as John Hussman has pointed out a little while ago, there is at least one data series that correlates even better with the US monetary base: the price of beer in Iceland. Correlation does not always mean causation.
And slightly off topic, in the context of odd correlations, we would be remiss not to tell our readers about this chart recently posted by '' on twitter. Finally we learn the true reason about global warming: it's not the fault of too much CO2 in the atmosphere, it is too much debt relative to GDP that is the culprit.
In our last update we pointed out that there were good reasons to be on alert for the possibility that a distribution pattern may be put in place. Since slight new highs have been made since then, no typical distribution pattern has formed yet (and the question whether a major peak has already been seen has been answered in the negative).
Nevertheless, the idea that we could at the very least be on the cusp of a bigger correction has actually been strengthened in light of the above. Especially the blow-off moves in the most speculative market sectors and the divergence between SPX and DAX strike us as important factoids in this context (recall also the previously discussed SPX/emerging markets divergence; it is the fact that divergences are showing up with very high frequency recently that is especially concerning). These are phenomena frequently observed prior to major trend reversals.
Charts by: StockCharts, Sentimentrader, B.C., Not-Jim-Cramer
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