Wednesday, July 22, 2015



A progressive internal deterioration of the market has been increasingly evident in recent months, and became severe last week. For example, the chart below compares the S&P 500 Index to the same 500 component stocks, but weighted equally rather than by market capitalization. While the difference may not seem significant, it also implies that even an equally-weighted portfolio of S&P 500 stocks, hedged with the S&P 500 index itself, would have lost several percent since mid-April.

The same observation holds for the Nasdaq index. The chart below is showing the Nasdaq 100 Index along with the ratio of the equal-weighted index to the float-weighted index. What's going on is that a handful of very, very large cap stocks account for an increasing share of the net gain, while the rank-and-file have been largely stagnant or in retreat.

Other measures of market participation have been equally problematic. The chart below compares the S&P 500 Index (upper red bars, left scale) with the percentage of stocks trading above their 100-day moving average (lower black bars, right scale). Fewer than half of all U.S. stocks remain above their 100-day moving averages, and only about half are above their 200-day averages.

The central lesson of market cycles across history, and even the most recent full cycle since 2007, is that the behavior of market internals is central to distinguishing an overvalued market that collapses from an overvalued market that continues to advance. Importantly, market outcomes in response to Federal Reserve easing are also dependent on the behavior of market internals. When market internals have deteriorated following extreme overvalued, overbought, overbullish conditions, even Federal Reserve easing has not reliably supported the stock market.

Once extreme overvalued, overbought, overbullish conditions are joined by a deterioration in market internals, even easier Fed policy does not provide reliable support for the stock market.

The typical, run-of-the-mill decline that completes a market cycle also typically wipes out 
more than half of the preceding bull market advance. This can be demonstrated in cycle after cycle across history. In recent cycles, because of relatively higher valuations at the market peak, the completion of the market cycle has wiped out years of prior market gains. We can't emphasize often enough that the 2000-2002 market loss wiped out the entire total return of the S&P 500 – in excess of Treasury bills – all the way back to May 1996, and that the 2007-2009 loss wiped out the entire excess return of the S&P 500 back to June 1995.

Even at present market extremes, it would require only a historically modest 30% market retreat to wipe out the entire total return that the S&P 500 has achieved in excess of risk-free Treasury bills over the past 15 years. Extreme valuations may not always have near-term consequences, but the long-term consequences are profound. Our actual expectation is that the completion of the current market cycle is likely to wipe out the entire total return of the S&P 500 – in excess of Treasury bill returns – all the way back to roughly October 1997; an outcome that would require a market retreat no larger than it experienced in the past two cycles. Presently, we anticipate negative total returns for the S&P 500 Index over the coming decade.

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