The Trick Divergences Play… They Make You Think They’re Not Working

DJIA:  35,213

The trick divergences play… they make you think they’re not working.  If you prefer the movie version, in The Usual Suspects, the line was the biggest trick the devil ever played was making you think he doesn’t exist.  So what’s a divergence, and what do we mean by not working?  The divergence in this case is between the large-cap averages, the Dow and S&P, and the average stock, measured by the Advance-Decline index.  As demand lessens the average stock and, hence, the A/D index peaks, while large-cap winners continue to climb higher.  As we have suggested before, the A/D index is more than just another technical indicator, it’s an insight into demand.  It takes money to push up 2500 stocks every day.  As demand lessens so, too, will the number of advancing issues.  Eventually the bad drag down the good, the average stock drags down the stock averages.  All well and good in both theory and reality, the problem comes down to timing.  In 2018 a few days resulted in a 20% decline, in 1987 the divergences lasted months.

Therein lies the problem.  There’s risk in a backdrop like this, a two month plus divergence between the averages and the A/D index, yet there’s plenty of money to be made.  By definition, the big stocks go up – will Nvidia (221) ever stop?  The dangerous part is that if you’re not in Nvidia, Microsoft (299) or the S&P, but instead you’re in the average stock, you’re in the A/D index.  You’re not making money but it’s okay because there’s hope.  As long as the S&P moves higher most days, there’s hope, hope your stocks will catch up.  Hope is a virtue in life, but a curse in the stock market.  The virtue in the stock market is discipline – stay with uptrends, cut your losses.  Divergences can go on and you can reap the S&P, or you can hope for the rest.  The longer these divergences last, the more you come to believe they don’t matter.  We’re not saying do nothing, we are saying whatever you do, do it carefully.

The market has taken on a better tone in the last few days, as often has been its way.  Just how it can go from three consecutive 2-to-1 down days to three consecutive 2-to-1 up days in a market that really isn’t trending, is a bit of a mystery.  Then, too, this market has tended to dodge technical pitfalls all year.  That said, there are still technical issues.  In a market that was at or near its high, NYSE new highs and new lows were even last week, while on the NASDAQ new lows were close to 3-to-1the number of new highs.  If you look to the percent of stocks above their 200 day average, that is, in uptrends, the number is around 50%–60% depending on whether you’re looking at NYSE stocks or a broader measure.  The markets, the big stocks, are making new highs with limited participation.  As a practical matter, to participate you pretty much have to go big.

A colleague recently pointed out a couple of stocks that no longer are what they may seem – in this case, a good thing.  SVB Financial (561) recently dropped “bank“ from its name, appropriate since the long term chart here looks nothing like that of a bank.  The chart is more that of a Tech stock, fitting given the former name of Silicon Valley Bank.  If not share alike, seems SVB has contrived to share and not just bank.  Another company possibly misunderstood is Honeywell (231).  It seems there’s more here than just the thermostat on your wall – not very techy, tech, as Penny would say.  Seems they’re now big in quantum computing, whatever that is, and other things that are techy, tech.

If you’re reading this hot off the presses, so to speak, Jay Powell may well be offering his much anticipated comments at Jackson Hole.  Nothing dire is anticipated, not even mention of “taper.”  Still, if he mentions the Fed balance sheet something could be made of that.  It has been pointed out that there is a correlation between the Fed’s balance sheet and the performance of secondary stocks, and we know the Russell 2000 has gone nowhere since early February.  The overall backdrop also makes his remarks worrisome – it’s one of those, the market makes the news sort of things.  The S&P is making new highs while there are as many 12-month lows as highs, and only about half of stocks are in uptrends – you don’t need us to tell you that’s not healthy.  Yet there are stocks acting well, the Big, making it hard to keep your hands out of the cookie jar.  Just know there’s a risk.

Frank D. Gretz

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US Strategy Weekly: Earnings Estimates and Inflation

Raising S&P Earnings Estimates

In our opinion, the crux of the 2021 stock market can be defined by two components: 1.) a strong earnings rebound and 2.) historically easy monetary policy.

Securities markets are always complex and cannot really be explained by two simple factors. Clearly there have been other influences this year such as the positive support from fiscal stimulus and promises of more stimulus ahead or the negative drag from the spread of the Delta virus variant, China’s crackdown on technology companies and the threat of rising corporate and individual taxes and fees. But perhaps the most unique and interesting development of 2021 is the appearance of a new generation of investors and the growing influence of social media on stock market activity. As a result, market volatility has increased driven predominantly by enthusiastic day traders monitoring message boards such as WallStreetBets on Reddit. Plus, there are a slew of geopolitical issues this year such as the slowing of the Chinese economy, China’s tightening grip on Hong Kong and Taiwan, the geopolitics of climate change, reversals in US energy policies and rising prices of oil, disputes between Poland, Hungary and EU institutions, Japan’s struggle with the Delta variant, and more recently the unfortunate global threat that the US pullout from Afghanistan, the fall of Kabul and the rise of the Taliban poses for the world.

Still, despite all these factors, investors can and will absorb a lot of bad news if earnings growth is strong – and to date, growth has definitely been strong. According to IBES Refinitiv’s report “This Week in Earnings”, with 476 of the 500 S&P companies reporting second quarter earnings, growth is expected to be nearly 95% YOY. Companies have been reporting quarterly earnings that are nearly 16% above estimates which compares to the long-term average surprise factor of 3.9%. This follows on the heels of IBES Refinitiv’s earnings growth estimate for the first quarter of 53% YOY. So as the second quarter earnings season ends, we are raising our 2021 SP 500 earnings estimates from $190 to $200, a 5% increase. However, this is a 19% increase from our December 2020 estimate of $168.60. We are also raising our 2022 estimate from $211 to $220, a 4% increase. In both cases we believe these estimates could prove to be conservative. See page 15.

This is good news for investors and this surge in earnings growth certainly supports equities. However, the easy comparisons from the pandemic-wreaked earnings quarters in the first half of 2020 are mostly behind us, and earnings growth is expected to slow to more typical levels of 30% in the third quarter and 21.6% in the fourth quarter. Despite the fact that strong gains in earnings have supported gains in the SPX, as seen in the charts on page 3, the run-up in the SPX relative to the gains seen in earnings has produced a significant valuation gap in both trailing and 12-month forward operating earnings. This valuation gap is similar to the one seen prior to the 2000 top. Another similarity between the 1997-2000 bull market and the current advance is the participation of a new generation of investors. A new generation of investors and a valuation disparity often go hand in hand and this characteristic of today’s market concerns us.   

Inflation is a tax on consumers and investors

While earnings have been strong in 2021, valuations still remain unusually high, and this is particularly true when inflation is taken into consideration. We often use the sum of inflation and the trailing PE as a benchmark to indicate when PE multiples are appropriate for the current level of inflation or as a warning when multiples get too high. In July with the CPI rising 5.4% YOY and the trailing PE at 24.5, the sum becomes 29.9, well above the standard deviation range. Since the top of the standard deviation range is 23.8, we call this The Rule of 23. See page 4. Note that the unusually high and sustained readings seen in this indicator recently are similar to those seen in 1999-2000 prior to the second worst bear market in history. Again, similarities to the 2000 market continue to grow.

Inflation will impact all investments. With 3-month and 10-year Treasury rates at 0.05% and 1.29%, respectively, equities remain competitive investments to fixed income. However, the chart on page 5 compares the history of interest rates and inflation and this chart suggests that unless inflation quickly drops below 1% YOY, interest rates on both the short and long end, are much too low and are likely to move higher. More ominously, a close inspection of the chart on page 5 also shows that a sharp rise in inflation, like that seen in 2021, has triggered eight of the eleven recessions seen over the last 75 years. This helps to explain the predicament the Federal Reserve faces this week as it meets in Jackson Hole WY. Interest rates are too low and accommodating given the level of inflation and the strength of the US economy. However, the pandemic-stricken economies of Europe and parts of Asia imply global growth may not be strong enough to withstand a change in Fed policy. Yet if the Fed allows inflation to continue to rise, it will inevitably end with even tighter and hawkish monetary policy in the years ahead which will almost guarantee an economic recession. It is not a simple problem. But it has been our view that the Fed needs to, and should have already, moved to neutralize its easy monetary policy in order to stifle inflation before it becomes ingrained in the system. This week we expect the Fed to steadily move the consensus view toward a reduction and possible elimination of quantitative easing. This is a necessary step to ensure the Fed is not stoking the flames of inflation. However, it will eliminate one of the two components that has underpinned the stock market’s advance.

Inflation is also having a negative impact on businesses. The NFIB Optimism Index decreased 2.8 points in July to 99.7, nearly reversing the 2.9-point gain in June’s report. Six of the 10 Index components declined, three improved, and one was unchanged. The NFIB Uncertainty Index decreased 7 points to 76, sales expectations decreased 11 points to a net negative 4 percent, owners expecting better business conditions over the next six months fell 8 points to a net negative 20, and earnings trends over the past three months declined 8 points to a net negative 13 percent. In sum, small businesses are becoming more concerned about their future given the current inflation and political environment. See page 6.

Technical Update

We are still focused on the Russell 2000 index (RUT – 2230.91) which has been trading in a sideways range for all of 2021. We believe it may give us clues about the stock market’s intermediate term direction. At present, the 200-day moving average (2160.82) is acting as support and the converging 50-day (2241.27) and 100-day (2247.88) moving averages — which are now decelerating — are acting as resistance. A breakout in the RUT from this narrowing range may define the broader market’s intermediate-term trend. There have been similar patterns in the RUT (trading between a rising 200-day moving average and decelerating 50- and 100-day moving averages) in the first half of 2011 and the second and third quarters of 2015. In both of these previous cases, the RUT broke below the 200-day moving average and this was the trigger for relatively sharp and fast corrections totaling 19.4% and 14%, respectively, in the SPX. Also worthy of note is the continued weakness in the 25-day up/down volume oscillator, which at 0.64 this week, is minimally above the lower half of neutral. This low reading implies that since early July volume has been as strong or stronger in declining issues as the volume seen in advancing stocks, i.e., investors have been selling into strength. And this week the 10-day average of new lows hit 101, before dipping to 99 on Tuesday. Nevertheless, this is close to the 100 new lows per day that defines a bear market. Daily new highs are still averaging 194, but the rise in daily new lows has shifted this indicator from positive to neutral. In short, we remain cautious and would focus on stocks with good value.  

Gail Dudack

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Good … but no DiMaggio!

DJIA:  35,499

Good … but no DiMaggio!  Some degree of adulation has been placed on the S&P, by the media at least, for its 47 new highs this year.  DiMaggio’s streak was 56, and it was consecutively!  And they don’t mention there was a similarly long streak before the crash of 87!  Let us hasten to say, this isn’t 87, but what’s important here is the trend, and not every tick in that trend.  This streak is easily explained by the fact we haven’t had a 5% correction since late last year, and that is impressive.  If you never go down, it’s not all that hard to make new highs.  We are all for uptrends, but we prefer the good old days pre-July 2, when it was the A/D index seemingly making daily new highs.  There’s more to those numbers than technical analysis Voodoo.  It takes money to push up 2700 stocks as was the case Wednesday.  The numbers are an insight into supply and demand.

It has been tough to know the players even with a scorecard.  Or has the distinction between re-open and stay-at-home simply become blurred?  Last week’s payroll number was taken to signal re-open, and bonds were sold.  The beneficiary here were the Financials, which had been more or less holding but clearly lagging.  The change was dramatic, with 60% of the sector hitting 20 day new highs, and names like Goldman Sachs (415), Morgan Stanley (105) and Wells Fargo (51), of all things, scoring impressive breakouts.  Another impressive move this week was in Steel.  Even Copper has acted better, despite the apparent slowdown in China.  Oil, too, with his own set of problems, has stabilized.  If all this speaks well to re-open, stay-at-home and, specifically, work from home, hasn’t exactly suffered – there’s an ETF for the latter.

The vaccine stocks Wednesday caught a downgrade by Isaac Newton, something about that gravity thing of his.  We mentioned on our Tuesday call that for Moderna (391) to be some 80% above its 50 day average was obscene.  Of course, there are no magic numbers here, we were more thinking along the lines of Supreme Court Justice Potter Stewart and his description of obscenity, “I know it when I see it.”  Down 77 points on Wednesday looked like a real buying opportunity, but down 30 seemed the same.  This latest move/break out was around 250, and carried to roughly 500.  A 50% retracement would be around 375, and Wednesday’s low was 372.  Were it that easy, this would be coming to you from the South of France.  If you would rather not sleep like a baby, that is, wake up crying every five minutes, you might consider the comparatively boring iShares Biotech ETF (IBB-169), where both Moderna and BioNTech (375) are among the top 10 holdings.

Speaking of gravity, Cathie Wood has had a tough go of it this year, understandable when Tesla (722) goes trading range on you and it’s 10% of several of her portfolios.  And to our thinking, stocks like Teladoc (145) and Roku (369) give her a leaning toward not “work from home,” but stay-at-home.  A move through 720 should get Tesla going again, and in her Ark Next Generation ETF (ARKW- 150) she has taken a liking to bitcoin, or cryptos in the form of COIN and GBTC (37).  As it happens, by the end of last week we had as well.  To use GBTC as a proxy, these stocks peaked in April coincident with the IPO of Coinbase (257). After basing for a couple of months, the gap above the 50 day caught our attention.  The stock recently seems to have resolved a little consolidation, as the 50 day begins to curl up.  After bottoming in May, COIN has stumbled around, but the recent move above 260 seems important.

August, September and October are a tough three months for the market, averaging less than a 1% gain in post-election years.  It’s even tougher for Ford (14) whose cumulative return since 1972 is minus 92% – your $1000 would have become $77, according to  The period might explain the lagging A/D’s since early July, though the better action in Financials should help – there are a lot of them.  Still, we are never comfortable with A/D’s diverging and would become particularly wary of up days in the averages with negative or flat A/D’s.  It’s easy to say the trend is up, but what trend?  The only real consistent uptrend has been in the S&P, as everything else just seems to rotate in and out of favor.  As the S&P’s performance would suggest, big has been better.  Even on the NASDAQ, 70% of stocks in the NASDAQ 100 are above their 50 day average but within the broader NASDAQ Composite, fewer than 40% of stocks are above the 50 day.  This speaks well of Tech, as does the S&P itself.

Frank D. Gretz

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