Mind The Internals: 80% Of Russell 3000 Are 10% Or More Below Their Highs

You’d think Wall Street analysts had other things to worry about these days. But no. A hype battle is brewing among them as to whether Apple or Google will be the first with a market capitalization of $1 trillion. In early 2000, the candidate was Cisco, before the very notion was obviated by events.

With the S&P 500 down only 6% from its September high, these analysts are not worried that Apple or Google would lose their footing like Cisco did in 2000. But beneath the surface, the bloodletting has been brutal. I received this note from an investor with decades of experience:

Subject: Holy Crap

In the past 5 days, I’ve hit 15 of my trailing stops. I just placed another batch of sell orders. All I have left is mostly cash, precious metals, and bonds. I had a lot of energy MLPs in my taxable account and they have been massacred – oil, gas, coal, midstream – everything. Buy-write funds ditto [funds that use a covered-call options strategy]. I have a few stocks left, but it’s pretty skimpy.

But one thing I’ve learned to never ignore: trailing stops despite fear of a whipsaw. I have always regretted waiting.

It wasn’t this way a week ago. On October 8, when the S&P 500 was just a good day below the magic level of 2000, UBS’s Intellectual Capital Blog explained it to the worried minions this way:

We’ve all read it somewhere (or maybe thought it): The recent dramatic small-cap underperformance must be some sort of signal. At a minimum, this must mean that: 1) it is time to abandon our long-standing small-cap overweight that we initiated in August 2012 or 2) the stock market is treading on thin ice, right? Well, as tempting as it is to believe that the market “must be telling us something,” the historical record is pretty clear and leads to the exact opposite conclusion.

In fact, a vicious rout in small caps – and that’s what these folks mean by underperformance – “is actually fairly bullish for both smalls-caps and the overall market.”

I won’t even try to get this straight.

Not a minute passes by when someone doesn’t explain to us incredulous souls that something bad, some kind of rout or wholesale destruction or a sneeze from China, is actually bullish, that in fact everything is bullish, no matter what, for a myriad reasons, including that the Fed will do another round of QE and save us all.

So on Monday, after a whiplash-inducing intraday just-buy-the-frigging-dip rally that collapsed spectacularly, the S&P 500 skidding through its 200-day moving average. That’s a crucial line for chart decipherers and trend prophesiers. The Dow and the Nasdaq have done so last week. The Dow had five triple-digit days in a row, four down, and one rip-roaring Fed-induced rally that lasted less than a day. Long live volatility. It’s back.

But it hasn’t registered yet, apparently. Axel Merk of Merk Investments dryly tweeted: “Judging from few emails brokers have received about market volatility, odds are we haven’t seen anything yet.”

The last time the S&P 500 dropped below its 200-day moving average was in 2012, twice, but recovered quickly. It taught everyone that dips of this nature were nothing but a “buying opportunity.” Just buy the frigging dip became the rallying cry. It worked better than anything else, and the dips became shorter and shallower as dip-buying set in more and more quickly.

Other times, falling below the 200-day moving average has turned into a broadly observed sell signal. And that’s the problem with technical analysis: it generates momentum and self-fulfilling prophesies, on the way up, and on the way down. But then there’s the direction of the line, currently still going up. So far, so good. If the indices stay below the line long enough, they’ll push the line into a southerly direction. And that would be a sign for all to see that the chemistry of the market has changed. By that time, the “holy crap” investor above will have been resting on his cash laurels for a while.

But beneath the skin, it looks much worse than the benign 200-day moving average: 80% of the stocks in the Russell 3000 are 10% or more below their highs, according to Bloomberg. Many of them have gotten demolished. Some have gone bankrupt as the appetite for high-risk debt at these low yields is drying up [read... Credit Bubble Begins to Exact its Pound of Flesh: GT Advanced Tech Soars, Crashes, and Burns]. That’s the bloodletting in small caps that UBS said was “actually fairly bullish.”

Cali Money Man, a seasoned wealth manager who sat at various desks during the last three crashes and hasn’t forgotten the lessons, observed that a large-scale decline in stock prices may become “disorderly on a scale we’ve not seen since 1987.”

Why? “Too many poorly understood structural changes have created unstable markets. It’s been unstable rising, which we’ve enjoyed. Now comes the dismount”:

Low liquidity in a rising market (liquidity evaporates with prices).

Phenomenally low trading volume, largely covered up by enormous volumes of high-frequency trades and ETF arbitrage.

Massive hedge fund speculators only lightly restrained by regulations on leverage, but unrestrained on selling into down markets.

Low confidence in the economy by retail and professional holders (esp. Boomers who cannot take another large drop, their 3rd in 15 years).

Record high use of technical analysis systems, which will give near-simultaneous, widely followed sell signals.

The effect of the massive switch to fee-based accounts during the past 6 years. We’re now fiduciaries (no matter what the fine print says). Collecting fees on the way up then watching it all evaporate will not look good. Yes, we tell ourselves that we’re now long-term strategic asset-allocators, hand-holding financial planners, and wealth advisors. But we forgot to tell our clients. They still think we’re investment managers. Either we’re going to sell on the way down; or get sued if the market goes down big but does not bounce back like it did last time. My guess is that we’ll sell.

And if this occurs with rising rates – so both stocks and bonds drop – it will get ugly fast.

None of these reasons have anything to do with sky-high valuations and the sheer distance that asset prices can plunge from their perch; or with corporate and economic fundamentals, a slowing world economy, or the implosion of China’s property bubble. These real-world reasons come on top of Cali Money Man’s structural reasons why the decline could become “disorderly.”

For chart decipherers and trend prophesiers, nothing is ever quite this unidirectional. Short term, the market is at the highest level this year of “oversold,” having skidded so much in such a short time, according to Bespoke Investment Group’s Overbought vs. Oversold chart. Nothing goes to heck in a straight line. A bounce would surprise no one at this point. And if enough chart decipherers and trend prophesiers believe that, they’ll produce another self-fulfilling prophesy.

Bank regulators are now fretting about the subprime auto-loan bubble, caused by reckless lending. They’re worried it will damage the banks. But when this doozie pops, it will hit sales, manufacturing, production, services, railroads…. It won’t go away quietly. Read… Debris from Subprime Auto Loans to Ricochet across Main Street

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