There has been a lot of discussion regarding the waning breadth of this stock market advance as it has set marginal new highs lately. Taking a step back I find it interesting to note that after an explosive 2013 advance, stocks began to lose momentum last year. The first half of 2015 has now seen the narrowest trading range in the history of the Dow Jones Industrial Average.
As a young kid one of my favorite toys to play with during the summer was a water rocket. It was just a little plastic, red rocket you would pour a bit water into and then pressurize with a hand pump before launching into the air. It feels as if the market is sort of like one of those rockets that has approached the apex of its flight. It’s now at the very short period of time where it’s almost frozen in the air before descending back to earth.
I recently came across a few studies which suggest this metaphor might be more apt than you may initially believe. Those of you who have been reading this blog for at least a few months know I like to look at not just fundamentals but sentiment and technicals, as well. These three studies fit this pattern.
Starting with sentiment, many pundits have been quick to dismiss margin debt as a useless indicator. However, I believe it is a very good indicator of investor sentiment. When they are eager to take on debt to fuel additional purchases of risk assets, clearly sentiment is more euphoric. When investors are keen to pay down margin debt the opposite is true. Ultimately, for this reason I believe margin debt is a very good indicator of risk appetites and potential supply and demand for stocks.
The statistics support this idea. As I recently demonstrated, margin debt relative to GDP has a very high correlation to future 3-year returns in the stock market. Right now, margin debt is forecasting about a 50% decline in stocks over the coming 3 years:
— Jesse Felder (@jessefelder) May 6, 2015
Next, in our technical study, the Dow Theory has been another one pundits have loved to hate lately. Even while the Dow Industrials have recently made new highs, the Transports have made a new 6-month low. Over the past 50 years, this sort of divergence has only happened at the 1973 and 2000 peaks, just prior to epic bear markets.
Finally, John Hussman recently overlaid a fundamental filter on top of a tight range study like I mentioned earlier. He finds that when stocks have traded so narrowly while being as highly overvalued as they are currently it has signified nearly every major stock market peak of the past century including 1929, 1937, 1965, 1973, 1999-2000 and 2007-2008:
— Jesse Felder (@jessefelder) May 11, 2015
Ultimately, the evidence is piling up and on many fronts (fundamental, sentiment and technical) that this bull market’s days could be done. Not only that, but the second-half of this full market cycle (busts follow booms like night follows day) will not be too different from what we should now have become accustomed to witnessing over the past 15 years.