Today, the Dow ended at an all-time high (priced in US$ that is) and the S&P 500 closed at a fresh 52-week high. On the surface, the market looks correction-proof – but under the surface, cracks are starting to show.

It was one month ago that the technical strength of the market began to deteriorate. Since April 16th, their have been some disturbing trends taking place in the market.

Two technical indicators that have historically been fairly accurate gauges of a bull market’s strength are Market Breadth and Leadership. While I track several sophisticated models to measure market breadth, I’m going to stick to a very simplistic view of it for the purpose of this post. I’d like to compare the performance of the Russell 2000 (RUT) which consists of 2000 small–cap stocks versus the Dow Jones Industrial Average (DJI) which consists of the 30 largest US stocks.

Since the close of business on April 16^th, the market has been open for 22 days. The DJI moved up on 18 of those days (82%), where as the RUT only went up 10 days (42%). During that span, the DJI is up slightly over 6%, where as the RUT is down almost 1.4%. That is a 7.4% disparity. A disparity of this magnitude has not taken place since the NASDAQ 100 underperformed the Dow and S&P 500 in similar fashion back in the early spring of 2000.

While breadth is starting to weaken, market leadership has been basically non-existent. Take today for example (5/16). Even though the DJI and S&P 500 are at 52 week highs, only 170 of the 3200+ stocks traded on the NYSE hit 52 week highs. This amounts to only 5% of the total shares traded. Leadership in the NASDAQ is even worse. NASDAQ shares saw an equal number of stocks hit new lows as hit new highs (116 new highs versus 117 new lows). While Large-cap names continue to push the market higher, the majority of stocks are not participating in the late stages of this bull market rally.

Either the underlying technical strength of the market will have to improve for the market to go much higher or we’re at the cusp of a new bear market. It will be interesting to see how it plays out.

By proceeding, I acknowledge that I have read and understood the Disclaimer, Performance Reporting Disclosure and Copyright Statements .

Dear Clients,

Ever since I turned bearish on the market last summer, I feared that there would be a brief period where I would underperform the market by a significant margin. March and April have turned out to be that period.

As of the end of February, my portfolios were outperforming the market by several percentage points, but the last two months have erased all my gains while equities experienced a rally (April was the best month for large caps since 2003). While I am disappointed by the short-term action in my portfolios, I have become increasingly confident in my strategy due to changes in the technical data that have developed over the past month.

The technical strength of the market took a definitive turn for the worse in second half of April which suggests that the odds of a bear market have increased significantly. It might take a while to play out but the likelihood of a correction is more apparent. I’ll address the technical issues later in the post. But first, here’s how my performance measured up to the market indexes through April 30th

PORTFOLIO	YTD RETURN
Core Portfolio	(1.2%)
Focus Portfolio	(4.2%)
S&P 500 (VFINX)	5.1%
NASDAQ 100 (QQQQ)	6.7%
Benchmark	4.3%

Not real pretty, but I expected that this might happen at some point. I can’t preciously time when to get out of the equity markets, but I have known for a while that equities have been far too risky to invest in. Furthermore, my portfolio has taken some hits while I’ve added volatile, non-equity positions (primary in the Commodity space) that I believe will appreciate substantially over the next couple of years.

In previous updates, I’ve compared current market conditions to that of 1973. In that market, precious metals and other commodities were highly volatile and susceptible to short-term market swings prior to experiencing unprecedented appreciation during the ’73 equity bear market. I believe that my portfolios are experiencing a similar set of circumstances.

Technical Indicators
First, I’d like to address the technical strength of the market. Of the 14 indicators I track to determine market risk, breadth and leadership are the two most acute in measuring the probability of a bear market. While the majority of my indicators have been bearish for some time, breadth and leadership remained resiliently bullish. In my March update I stated that Leadership had turned neutral but breadth was still bullish – and that held true until April 17th. Since then, market breadth has taken a considerable turn for the worse. While it is not quite in bearish territory, it’s getting there. Here are a few examples of the breakdown in market breadth.

1. In the month of April, 50% of the gains in the Dow Jones Industrial Index (DJI) were generated by just 5 stocks (The index consists of 30 stocks).
2. From April 17th til the 30th, there were 10 market days. Of those 10 days, there were 5 days were the DJI rose while the Russell 2000 (RUT) index fell. (In a healthy market environment, the RUT has more beta than the DJI so if the DJI goes up, the RUT should go up even more.)
3. From April 17th til the 30th, the DJI appreciated 2.7%, while the RUT declined 2%, meaning that Small Cap stocks underperformed large caps by 4.7%. (For the month, the DJI outperformed RUT by a 4% margin.)

(I compare the Russell 2000 (RUT) index to the DJI or S&P 500 to create a crude measure of market breadth because it contains many more stocks and Small Cap stocks typically fall before large caps do. In addition, I track far more sophisticated models of market breadth that are deteriorating as well.)

Market leadership has been lackluster for quite some time now. Leadership is not providing a compelling reason to be long or short the US equity markets. Given that the major market indexes are at 52-week highs, market leadership would have to turn decisively bullish before the market would go much higher. Without an improvement in leadership, there will likely be some sort of correction in the near term. Depending on how Market Breadth holds up during a pullback, it should provide me a good indication of whether the bear market has begun. And if so, expect sideways trading with gut-wrenching volatility over the next couple of months.

Forward Strategy

As you know from my March update, I’m investing your account to profit during a period of economic Stagflation. There have only been two prominent periods of economic stagflation in the last 80 years (late 30’s and the 70’s), so very few advisors will be familiar with ways to protect their client’s assets during the difficult times ahead. While the market continues to act as if Stagflation is not even a consideration, the economic and inflation data are continually making a stronger case for it.

In my previous post, I updated the data that I sent to you in March relative to the probability of stagflation. You can read it by simply scrolling down. I also posted a copy of the original data I sent to you which you can access by clicking HERE.

Conclusion

My portfolio has underperformed the market while investors have seemingly sunk into a deeper state of denial about the prospect of stagflation. The data clearly makes a strong fundamental case in favor of my portfolio, but as I’ve said numerous times, the market can act irrationally for very long periods of time. Eventually, investment fundamentals will take over. We just have to remain patient while it plays out. The breakdown in technical strength over the last few weeks suggests that our patience may not be tested for much longer.

As always, call me if you have any questions regarding your account.

All the best,

Matt