Junk Equity Index Signals Financial Stress

Tariff News Driving The S&P 500

The chart below shows the S&P 500 since December. The tariff announcements are labeled along with the 33 day moving average and pivot points. The relative strength index is in the top chart. This correction has been longer than the average one. Judging based on the action before the steel tariffs were announced, it looks like the correction could’ve ended in early March if this trade scuffle never happened. The chart doesn’t show the latest rally on Tuesday in which stocks increased after President Xi’s speech which supported opening up the Chinese market to freer trade with lower tariffs. As you can see, sometimes stocks bounce off the moving average, while other times they ignored it. That’s what happens in a range bound market which doesn’t have a trend.

S&P 500 Breadth Indicators

The chart below shows the 200 day moving average. As you can see, the highlighted points show when the market fell below the 200 day moving average. They were the best buying opportunities of this bull market. This business cycle has been unique in that it has now had 4 slowing periods within the expansion. You could almost consider them recessions if the economy was growing at the rate it did in previous decades. However, this entire cycle has been relatively weak so they are clearly defined as slowdowns. An elongated growth cycle with many slowdowns is consistent with multiple periods where the S&P 500 falls below the 200 day moving average without the bull run ending.

The two charts below are breadth indicators. They are the percentage of stocks in the S&P 500 which are below their 50 day and 200 day moving average. The percentage of stocks below their 50 day moving average troughed in this correction close to the trough of previous corrections in this bull market. The percentage of firms below their 200 day moving average hasn’t reached levels seen in the previous correction. This might be because this correction has been centered around tech stocks and firms directly affected by the tariffs.

Junk Equity Index Is At Extreme Levels

The chart below shows Societe Generale SA’s volatility index. The quant team created a junk volatility index which shows the difference between stocks with weak balance sheets and stocks with strong balance sheets. Stocks with weak balance sheets aren’t bothered when the financial conditions are healthy, but when they are stressed, issues emerge. This explains the quote by Warren Buffett in which he says “only when the tide goes out do you discover who's been swimming naked.” The overly indebted firms will run into issues when the next recession occurs. This collateral damage in recessions is what makes them so problematic.

The issue this cycle is there are many firms which are leveraged. If interest rates rise, many firms will be considered swimming naked. The indicator is currently at the 97th percentile. I think this index is much too sensitive to movements in the market. The idea that the index can’t get any worse than the winter of 2016 is clearly wrong because that wasn’t even a recessionary period. Like I’ve been saying about the 200 day moving average, I think this indicator should be faded because the fundamentals don’t justify this much financial stress.

FANG Performance Reviewed

As I mentioned in a previous post, Mark Zuckerberg is being questioned at a Senate hearing. This is great news for the stock because the Senators aren’t asking pertinent questions. Senators are middle aged or older in most cases which is one reason why they don’t have a great understanding of what Facebook does and what the terms of conditions are in the user agreement. Facebook stock was up 0.78% on Wednesday. It’s now up 9.26% from the bottom in March. Facebook is a member of the FANG stocks which are the momentum names which have lead this bull market.

The chart below shows the change in market cap in the FANG names as compared with the change in the market cap of the entire S&P 500. FANG had its best year in market cap improvement in 2017 in which it gained $794 billion which was 22.35% of the S&P 500’s gain. The average gain from 2012 to 2017 was 16.64%. The percentage has the potential to be larger in 2018 since the firms are bigger. So far, these momentum names have had a mixed start. Amazon is up 22%, Facebook is down 6%, Netflix is up 58%, and Alphabet is down 3%. If Facebook and Alphabet regain their momentum after this correction, the total percentage improvement will be way above the 2012-2017 average.

Modern Day Asset Bubbles

I like to show conflicting viewpoints to show both sides of the debate. Only showing one side wouldn’t give you the entire story. The chart below shows the modern day bubbles in terms of their percentage gains. Gold was in a bubble in the 1970s and 1980s. The Nikkei was in the biggest bubble ever in my opinion based on the valuation metrics. This just shows the percentage increase. Tech was the biggest bubble in American history although the housing bubble did more damage to the economy. Biotech has quietly declined in the past 2 years after it hit its bubble peak. Not all the bubbles gave their entire gain back, but I still think biotech has more room to fall.

The latest bubble on this list is e-commerce which is why this chart runs counter to the bullish narrative on FANG. Amazon is the main player in e-commerce, but Facebook and Alphabet are both effected by it too. They both sell ads which drives e-commerce sales. Facebook has also released a service called Marketplace which lets people buy and sell items similar to eBay. If the e-commerce bubble were to pop, FANG wouldn’t exist anymore. It’s far from a guarantee that this is a bubble because e-commerce is taking market share from physical stores. The biggest problem with e-commerce is the margins are razor thin. Amazon’s profitability is driven by its web services division.

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