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INSIDE THE STOCK MARKET

...trends, cross-currents, and outlook


Prepared by: Doug Ramsey, unless otherwise noted
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Major Trend Index Holds Just Above Negative Zone


For the first time in two years, the MTIs Attitudinal category moved into positive territory at the end of
July. Both the June and July Green Books pointed out that, in the past, the same development coincided
with several important short and intermediate-term stock market lows.

Too Many Highs, Too Many Lows


The High/Low Logic Index, developed by market analyst Norman Fosback in the 1970s, provides one
way to assess whether internal market disparities have become dangerously extreme.

Valuation Gap In Chinese Equity Market


A-shares are overvalued relative to Chinese companies listed in Hong Kong and the U.S. These overseas
issues are still the better bet for investors bullish on Chinas long-term outlook.

On High Alert
August is National Eye Exam Month, but this is the rare year we can confidently recommend
that you skip it. Warnings of stock market trouble have become clearer to see without thick lenses
or squinting. We can, just barely, make out the big E at the top of the eye chart, and suspect it means
to Exit. We made another move in that direction in late July, cutting net equity exposure in tactical
funds to 48%, from 55% in early July, and down from 61% six weeks ago.
The Major Trend Index (MTI), along with related disciplines we look to for substantiation and
reinforcement, are on the brink of negative signals. The table has already been set. Stock market valuations have been dangerous for at least a couple of years, and the Fed is slowly pulling away from its
reckless experimentationa good thing in the long term, but not for stocks in the intermediate term.
Current stock market breadth, leadership, and momentum are all characteristic of a very late stage bull
market. The smallest amount of additional confirmation will send us to an even more defensive posturebut we recognize the hazards of waiting for too much evidence to fall into place.

If the seasonal pattern of the past quarter century holds sway, that bearish signal should arrive this month. Yet another year well have to miss out on the Hamptons
MSCI World Index:
Average Monthy Performance, 1988 To Date
3.0

2015 The Leuthold Group

2.0
1.0
0.0
-1.0
-2.0
Jan

Feb

Mar

The Leuthold GroupAugust 2015

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

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Stock Market Observations


The U.S. stock market has largely shrugged off the latest round of worries related to Chinas
stock market collapse, the new down-leg in crude oil, a more hawkish tone in Fed-speak, and sizable
second-quarter declines in S&P 500 sales and earnings. Investors have had a more difficult time
shrugging off those concerns, however. For the first time in two years, the MTIs Attitudinal category
moved into positive territory at the end of July. Both the June and July Green Books pointed out that, in
the past, the same development coincided with several important short and intermediate-term stock market lows. Should contrarians gear up for a late summer rally? We dont think so.
The improvement in sentiment is
encouraging, but not sufficient to trump
the deterioration seen elsewhere in the
MTI and related stock market tools. In
particular, our market action work (i.e., the
Momentum/Breadth/Divergence category)
has sunk to its lowest level since the immediate aftermath of the severe 2011 market
decline.
For what seems like forever, weve
been willing to downplay legitimate overvaluation concerns by explaining that, technically, valuations could become even more
inflated, so long as the stock market continued to be in gear. (Or uniform,
egalitarian, cohesive or other jargon
meant to provide some variation on a trend
that obviously outlived our vocabulary.) But,
we cant make that argument any longer.
For what seems like forever, weve
published the accompanying chartwe even
devised a simple Red Flag Indicator
around it a few months ago. The bulls point
out that not all of the red flags are flying.
However, while the Russell 2000 and S&P
Financials did not confirm the May 21st high
in the S&P 500, both have subsequently recorded new cycle highs. The broader picture
(look at the chart from an arms length) is
now clearly one of fracturing (or
divergence, distribution, bifurcation).
Fortunately, the market topping process is
now so advanced that our readers shouldnt
have to suffer through these tortured descriptions for much longer. The next big move in
stocks should be down. Consequently,
were significantly more defensive than two
months ago (48% net equity exposure versus
61% six weeks ago), and we expect to get
more so as our disciplines allow.
The Leuthold GroupAugust 2015

May 21, 2015


latest S&P 500 bull market high

S&P 500
2000

2000

1800

1800

Dow Jones 65
Composite

6500

6500

6000

6000

5500

5500

Dow Jones Transports

9000

9000

8500

8500

8000

8000

7500

7500

7000

7000

650

650

Dow Jones Utilities

600

600

550

550

500

500

1300

1300

Russell 2000

1200

1200

1100

1100

S&P 500 Financials


300

300

S&P 500 Cyclical


Sector Index*

460
440

460
440

420

420

400

400

380

380

NYSE Advance/Decline Line

46000

46000

44000

44000

42000

42000

2015 The Leuthold Group x10

x10

2014

M A

M J

N D

2015

M J

*Equal-weighted composite of Consumer Discretionary, Industrials &


Materials sectors.

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Weakening Foundation
Over the last few months, weve presented a couple of simple quantitative studies meant to encapsulate the factors driving our Major Trend Index to the brink of bear territory. The chart and table
might provide the best summary yet.

Leadership (Dow Jones Transportation and Utility Averages), breadth (NYSE Weekly Advance/
Decline Line), and corporate credit (DJ Corporate Bond Index) have all staged intermediateterm breakdowns by falling below their respective 40-week moving averages. But the S&P 500
has, through early August, remained impervious to this underlying trouble, holding above its
own 40-week average and within 1-2% of a new cyclical high.

The bull market has ground on for so long that its tempting to ignore these internal warnings. After all, the chart shows several intermittent periods of weakness in Transports, Utilities,
NYSE breadth and/or corporate bonds since the 2009 low. But the past six weeks represent
the first period since 2008-2009 that all four series have simultaneously been in 40-week
downtrends. The accompanying performance table shows that average S&P 500 annualized
returns have been about zero under identical scenarios but those average returns include
significant pieces of the 1990, 2000-2002, and 2007-2009 bear markets.
2015 The Leuthold Group

2000

2000

S&P 500
(weekly)

1500

1500

1000

1000

Dow Jones
Transportation Average
5000

5000

Dow Jones
Utility Average

600
500

600
500

400

400

300
4500

300
4500

Market Status
Transports, Utilities,
NYSE Breadth & Bonds
above 40-wk moving avg.
Three of four series
above 40-wk moving
average
Two of four series
above 40-wk moving
average
One of four series
above 40-wk moving
average
None of four series
above 40-wk moving
average

S&P 500
Ann.
Gain

Pct. Of
Time

+15.3%

35%

+6.8%

22%

+7.5%

16%

-3.3%

11%

-0.1%

16%

Results for period April 1941 to date.

4000

NYSE Weekly
Advance/Decline
Line

4000

120

120

110

110

Dow Jones
Corporate Bond Index

100
90

100
90

2015 The Leuthold Group

2007

2008

2009

2010

2011

2012

2013

2014

2015

All series shown with their 40-week moving averages.

The Leuthold GroupAugust 2015

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Fed Watching For The 21st Century


Weve become a bit self-conscious about the extent to which market action analysis has
grown to be a larger share of our commentary in the last few years (Charts 1, 2). But, such analysis is a
critical piece of our broader allocation workand one that (we think) grows in importance during the
later innings of a bull market, when even sell-side market strategists are struggling to make a valuation
case for stocks. Measures conventionally disChart 1
missed/dissed as purely technical, in fact, help us
S&P
500,
MidCap
400
&
2100
1700
gauge the liquidity backdrop for stocks. For inSmallCap 600
500
2000
stance, in light of the preponderance of NYSE(right scale)
1600 Indexes
listed issues that are interest rate sensitive, weve
1900
argued for years that analysis of market breadth
1500
is simply an alternative (or perhaps complemen400
1800
(left scale)
tary) approach to the more gentlemanly pursuit of
1400
Fed watching.
1700
1300

The Feds creativity during the post2008 period has been lauded, but it has undermined several fundamental relationships we once
considered reliable. (We wrote an Of Special
Interest piece on this topic in 2011 thats overdue for an update.) For example, the rate of
change in short-term interest rates explodes
when rates are at zero. This is a stock market indicator first proposed at least a hundred years
ago. Quantitative Easing compromised the
once-revered message of the money supply
measures, and a few years back, the Fed expunged a large set of valuable bank reserve data
in a manner that would make Lois Lerner blush.
These developments have increasingly forced us
to monitor Fed policy in a sort of second derivative fashioni.e., by monitoring movements in
the asset markets themselves.

700
650

650

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600
2014

N D

2015

M J

600

Chart 2

S&P 500, 400 & 600


Daily A/D Lines

Dec 29th

500

500

500

450

450

May 18th

400
400

400

Jun 23rd

350

The sudden struggle of equal-weighted


stock market indexes might well reflect the impact of tightening thats either already occurred
(the lagged impact of seven QE tapering moves),
or that is still to come. Several of these equalweighted indexes have gone into relative strength
free-falls over the past six weeks (Chart 3), and
the Guggenheim Russell 2000 Equal Weight ETF
(EWRS) has already suffered an official,
CNBC-approved correction of 10% into its July
27th low.

350

600
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2014

M J

N D

2015

M J

Chart 3
160

S&P 500, 400 & 600:


Equal/Cap-Wtd RS Ratios

160

158

158

500
156

156

82.0
81.5
81.0
80.5
80.0
79.5

In sum, deteriorating stock market


breadth and worrisome leadership trends both
suggest liquidity has already tightened; whether the Fed follows suit in September may now be
just a formality.
The Leuthold GroupAugust 2015

700

600

600

125
124
123
122
121
120
119

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2014

82.0
81.5
81.0
80.5
80.0
79.5

400

M A

M J

N D

2015

M J

125
124
123
122
121
120
119

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Too Many Highs, Too Many Lows


Weve detailed the growing degree of stock market bifurcation, but the problem for would-be
bears is that such bifurcation can reach astonishing levels (witness 1999-2000) before the market is set
to peak out. The High/Low Logic Index, developed by market analyst Norman Fosback in the 1970s,
provides one way to assess whether internal market disparities have become dangerously extreme.
The weekly NYSE High/
Low Logic Index is calculated as
the lesser of: (1) new 52-week
highs as a percentage of NYSE
issues traded; or (2) new 52-week
lows as a percentage of NYSE
issues traded. For analytical purposes, the figure is generally
smoothed with a short- to intermediate-term moving average (we
use 10 weeks). High readings indicate simultaneously large numbers
of stocks making highs and lows,
indicating a dangerously high degree of internal divergence.

Chart 1
2015 The Leuthold Group

2000

2000

S&P 500
NYSE new
52-week highs
and lows are both
at elevated levels,
a sign the stock
market has
become internally
fractured.

1500

1000

The bifurcation within the


NYSE might come as no surprise,
given its extreme underperformance versus the NASDAQ market in the last year. But the High/
Low Logic Index for NASDAQ
(Chart 2) shows a similar level of
discord; its 10-week moving average has just entered the bearish
zone. Note that similar readings
appeared immediately before the
market collapses of 2000-2002
and 2007-2009, and did not experience the bothersome false signals issued by the NYSE version
of the indicator.
The Leuthold GroupAugust 2015

Above 5% - Tape is "divergent"- BEARISH

The High/Low Logic Index entered 2015 at a maximum


bearish reading above 5% (Chart
1), and following a four-month
respite, has again spiked into this
danger zone. We recognize that
the indicator issued a set of failed
signals in the second half of 2013,
but todays bear signal occurs
with a broader array of supporting
bearish evidence than two years
ago.

(10-Wk. Avg.)

1000

false
signals

NYSE High/Low Logic Index*

1500

Below 1% - Tape is "in gear"- BULLISH

0
2007

2008

2009

2010

2011

2012

2013

2014

2015

*Index calculated as the lesser of NYSE Weekly New Highs and New Lows
as a percentage of issues traded.

Chart 2
5500
5000
4500

5500
5000
4500

NASDAQ Composite

4000

4000

3500

3500

3000

3000

2500

2500

2000

2000

1500

1500

NASDAQ High/Low Logic Index*


(10-Wk. Avg.)
Above 6% Tape is divergent = BEARISH

7
6
5
4
3
2
1
0

7
6
5
4
3

Below 1.5% - Tape is in gear - BULLISH

99

00

01

02

03

04

05

06

07

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08

010 10

11

12

13

14

2
1
0

15

*Index calculated as the lesser of NASDAQ Weekly New Highs and New
Lows as a percentage of issues traded.

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Minding The Gaps


We think stock market action in the next few months will provide the Fed with an excuse
to skip any rate increase in 2015. But our view is a minority one, and futures market odds on a September increase shot up in early August. Either way, the obsession over the timing of a Fed rate hike
ignores the fact that world P/E ratios are already contractingat least on the basis of our 5-Year Normalized EPS.

Normalized P/E ratios


for both the U.S. and
foreign
Developed
markets peaked in
June 2014, and the
latter is down significantly (16.9x in July,
down from a peak of
19.5x). Emerging Market Normalized P/E
ratios are flirting with
their 2001 and 2011
lows. But the declines
have done nothing to
close the U.S./foreign
valuation gaps.

40

Normalized P/E Ratios: U.S.


Vs. Rest Of World

35

35

30

30

MSCI USA Index


25

25

22.3x
20

20

16.9x
(World
Ex USA)

15

2015 The Leuthold Group

92

94

15

11.2x
(Emerging
Markets)

10

90

The Leuthold GroupAugust 2015

40

Foreign
Valuation Gaps Are
Still Gaping...

96

98

00

02

04

06

08

10

12

14

16

10

18

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Emerging Markets: A Half-Off Sale!


The Chinese governments repeated stock market intervention attempts over the past several
weeks have been remarkable, and obviously antithetical to the countrys move toward a more laissez
faire corporate environment. Butwith the Shanghai Composite still up 66% (Chart 1) in the last 12
monthsare artificial supports even necessary? Its akin to keeping interest rates at zero during
the seventh year of a bull market and economic expansion.
The July swoon drove Emerging Market equities down to relative valuation levels seen only
very briefly during their (admittedly short) history. The MSCI Emerging Markets Index now trades at a
5-Year Normalized P/E of 11.15xan exact 50% discount to the same calculation for the MSCI USA
Index (Chart 2). Well admit the valuation gap has become so wide that were increasingly tempted to
override our EM Allocation Model (which has presciently remained bearish for the past 4 1/2 years,
Chart 3). But we fear this gap might not begin to reverse until a cyclical bear market erupts; this months
Of Special Interest section reinforces our long-time argument that value-based approaches are prone to
stumble during the bulls final charge.
Chart 2
Chart 1

Shanghai
Composite

5200

MSCI Emerging Markets Vs. USA


Relative P/E on 5-Yr.
Normalized EPS

1.35
1.30
1.25
1.20

(weekly)

1.15
1.10

5000

1.05
1.00
4800

0.95
0.90
0.85

4600

0.80
0.75
4400

0.70
0.65
0.60

4200

4000

0.55

now at a
50% discount

0.50
0.45

2015 The Leuthold Group

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Chart 3

3800

0.50

3600

Emerging Vs. Developed Markets


Allocation Model

0.45

0.45

0.40
0.35

3400

down almost
a third-but still a nice
gain on the
year

0.30

Total Return Ratio,


MSCI Emerging Markets/
MSCI World Index
(USD - Monthly)

February

April

May

June

July

August

0.40
0.35
0.30

0.25

0.25

0.20

0.20

0.15

0.15

0.10

0.10

EM Allocation Model*

1.2

2015

LATEST
SIGNAL:
Switch into
MSCI World
Index
on February 28,
2011.

3200

3000

2015 The Leuthold Group

0.50

1.2

1.1

1.1

1.0

1.0

0.9
0.8

0.9
2015 The Leuthold Group

model "reiterated" a SELL signal in July

0.8

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

*Buy Emerging Markets when Total Return Ratio breaks above upper band, and remain positioned
there until Ratio drops below lower band, triggering a switch into the MSCI World Index.

The Leuthold GroupAugust 2015

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The 30/30 Club!


The S&P 500 Energy sectors latest plunge puts it down by almost a third in the last 14 months,
placing it among the worst isolated sector declines in recent history (Chart 1). In January, we noted
Energy had already suffered a 20% loss outside of a broader cyclical bear market; there have been only
19 other instances of such stand-alone sector bear markets since 1990. But Energy now belongs to
the considerably more exclusive list of sectors which have declined 30% on both an absolute basis
and relative to the S&P 500yes, the 30/30 Club!
With only three prior cases to consider (Charts 2-4), we shouldnt draw generalizations. But we
cant help it: Note that when these other stand-alone sector declines came to an end, either a broad
market correction (1994) or bear
Chart 1
market (2000-2002) was on the im760
740
mediate horizon. The message may
720
be that when liquidity is no longer
700
sufficient enough to float all of the
S&P 500
680
sector boats, trouble may soon be on
Energy
660
the way. Again, theres not enough
(daily)
640
history to say.
620

With Energy groups still ranking near the bottom of our GS framework (Refiners are the exception), is it
time to worry about Energy joining
the 40/40 Club (40% decline/40% underperformance)? Only the Consumer
Staples sector has achieved that status
(appropriately enough, during the
peak of baseballs steroids era from
1998 to 2000).

600
580
560
540
520

-32.8%
(August 4th)

2015 The Leuthold Group

2014

Mar Apr

500

May Jun

Jul

Aug Sep Oct

Nov Dec 2015

Mar

Apr

Chart 2

May Jun

Jul

Aug Sep

Chart 3

105

265
260
255
250
245
240
235

100

230
225

95

220

125
120

S&P 500
Health Care

115
110

1992-1993

215

90

210
205

85

200

80

-38.6%

2015 The Leuthold Group

1992 M A
N D 1992

M J

A S O

1993 M A M J
N D 1993

75

S O N

Chart 4
170

195
190

S&P 500
Consumer
Staples

185
180
175
170

1998-2000

165
160

165

155

160
155
150

-40.8%
2015 The Leuthold Group

O N D 1999
1999 M A M J

150
145

2000 M A M
J A S O N D 2000

145
140
135

S&P 500
Materials

130
125

1999-2000

120

-30.0%

2015 The Leuthold Group

1999
1999 M

The Leuthold GroupAugust 2015

M J

10

2000 M
2000

115
M

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The 30/30 Club (continued)


Is a severe, isolated sector decline like Energys apt to be followed by outperformance? Based
on our tiny sample, the answer is yes.

As shown in Table 1, Health Care, Staples, and Materials sectors all reversed their 30/30 underperformance during the subsequent two years, beating the S&P 500 by an average margin of
+47.6%.
Table 1

The 30/30 Club:

S&P 500 Sectors To Have Declined 30% On Both An Absolute And Relative Basis
Outside Of A Cyclical Bear Market

Pct
Decline

Pct
Decline
Rel to
S&P 500

Relative
Perf.
Next
6 Mos.

Relative
Perf.
Next
12 Mos.

Relative
Perf.
Next
24 Mos.

16.3 %

57.7 %

67.7 %

Sector

Dates

Consumer Staples

November 23, 1998 - March 14, 2000

-40.8 %

-55.1 %

Energy

June 23, 2014 - August 4, 2015

-32.8

-39.4

Health Care

January 9, 1992 - August 12, 1993

-38.6

-46.1

9.4

16.1

37.9

Materials

May 6, 1999 - March 7, 2000

-30.0

-31.8

-11.3

23.1

37.3

Average

-35.5 %

-43.1 %

32.3 %

47.6 %

*Cyclical Bear Markets in the S&P 500:


July 16, 1990 - October 11, 1990
July 17, 1998 - August 31, 1998
March 24, 2000 - October 9, 2002
October 9, 2007 - March 9, 2009
April 29, 2011 - October 3, 2011

4.8 %

After the decline ended,


forward sector relative returns from
this tiny sample were excellent.

2015 The Leuthold Group

Chart 5

With our focus (and, for that matter, most


everyones) on the S&P 500 lately, we nearly
overlooked some of the incredible stats being
put up these days in the minor leagues. Think
the 30/30 Club is a big deal? Theres a Small
Cap sector thats just joined the 60/60 Club!
Yes, the S&P SmallCap 600 Energy sector
had declined 64.0% into its August 4th low
(Chart 5), underperforming the S&P SmallCap 600 by 67.8% since June 30, 2014.
Again, Energy groups (save for the Refiners)
rate poorly in our Group Selection (GS)
model, and we dont have a separate framework to handle the Small Cap groups. But
this chart finally smacks of capitulation

The Leuthold GroupAugust 2015

S&P SmallCap 600


Energy Sector

2000
1900
1800
1700
1600
1500
1400
1300
1200
1100
1000
900
800

-64.0%
2015 The Leuthold Group

2011

11

2012

700

(August 4th)

2013

2014

2015

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Avoiding Gold
The vast majority of recent gold commentary centers on its extremely oversold technical condition and the related washout in all sorts of sentiment indicators, ranging from trader surveys to futures
and options positioning. Maybe these conditions will produce a short-term bounce, but were going to
stand with the message of our bearish longer-term work.
Chart 1

Oversold is in the eye of the beholder.


Golds four-year decline of around 40% does not look
all that cathartic on a monthly chart, especially one
thats logarithmically scaled like the accompanying
Chart 1. Bullion would need to drop another 40%
to reach its median long-term ratio versus the
Consumer Price Index. And the ratios many years
of levitation above its median raises the odds of an
overshoot, when and if that median is crossed. (Weve
expressed the same concern over crude oil, which
for all the carnage its collapse has triggeredhas
merely returned to an average level on a CPI-adjusted
basis.)

Gold Futures

2000

(monthly)

1800
1600

Gold's 40%
decline still
looks
muted on a
logarithmic
scale...

1400

1200

1000

800

$693
Implied
target
if the
Gold/CPI
Ratio falls
to its 1970to-date
median.

Golds action has historically been a pretty


good harbinger of near-term price trends for industrial
commodities, although the relationship has weakened
since the onset of the Great Recession. Historically,
the 12-month rate of change in gold has led the 12month rate of change in the CRB Raw Industrials by
about six months (Chart 2). Based on that trend,
golds 12-month decline of 15% suggests further
near term weakness in the CRB (even though the
latter also looks oversold in price and washed out on
the basis of most sentiment measures).

600

400

2015 The Leuthold Group

2000

2010

Chart 2

200

2015 The Leuthold Group

Gold's Action Points To Even


Lower Prices For Industrial
Commodities

150

200

150

100

100

12-Mo. Pct. Chg. In Spot Gold,


Advanced 6 Months
50

50

12-Mo. Pct. Chg. In


CRB Raw Industrials
-50

-50
70

72

74

76

78

The Leuthold GroupAugust 2015

80

82

84

86

88

90

92

94

12

96

98

00

02

04

06

08

10

12

14

16

18

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