Sidelines? What Sidelines?

| About: SPDR S&P (SPY)

Last week we wrote a piece on how we had sensed that fewer and fewer ships were supported by the rising tide of the US share market. This tide has been fueled by stimulus generously dispersed by the Fed and its counterparts in other world regions and has been purring away for the most of the past four and a half years.

Our observations indicated a change in sentiment that did not quite fit with the steady juggernaut of the upwards trending S&P500 index represented by the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) or the Dow Jones index represented by the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) in the chart shown below.

The mentioned change in sentiment happened around the time the term "Septaper" was coined conveniently filling news columns during summer doldrums. The prospect of scaling back the enormous monthly expansion of the Fed's balance sheet seemed to support a sentiment of taking money off the table and selecting investments more carefully and selectively than before.

SPY Chart

SPY data by YCharts

Our observation was supported by a decreasing count of companies listed on the NYSE participating in the bull market. Such a decrease in the number of advancing stocks has often served as an early indicator of market tops in history. In such a scenario fewer and fewer ships are actually lifted by the tide of a bull market and an increasing number of participants get left behind. We raised this observation of this change in sentiment in last week's article and supported our findings with a chart of the A/D line for the NYSE.

Many valuable comments were posted in response to our article for which we are grateful. This week we would like to quote fellow contributor at Seeking Alpha Del Lindley with his comment to our article:

"Other than market folklore (e.g. the statistical analysis of historical data) why should we expect the A/D line divergence to anticipate a decline in the S&P 500 index? Recall that the A/D line is just based on the unweighted difference between the number of rising and falling share prices. The S&P index is float-weighted, where the components with the greatest floats have a greater impact (for a given price change) on the index than the "least float" shares. The current divergence could be explained by a preferential price increase in a small number of large float shares at the expense of a greater number of smaller float stocks. Should this rotation be considered a "flight to safety" (now that gold and bonds seem to be suspect) that qualifies as a market warning signal?"

We felt the urge to consider this argument more closely and proceeded to check the performance of the S&P 500 top holdings for some signs of the presumed "flight to safety" effect. We expected to see large-cap members of the S&P 500 outperforming the index if this argument was true and sentiment had been swinging towards the perceived safety of these blue-chip stocks.

The chart below shows the performance of the S&P 500 in comparison with the top ten holdings of this weighted index since March this year. The distribution was very even: 5 companies outperformed the index, and 5 underperformed. Top performer Microsoft (NASDAQ:MSFT) was 11% ahead of the S&P 500 at the time of writing and bottom performer Exxon Mobil (NYSE:XOM) had underperformed by 16%.

SPY Chart

SPY data by YCharts

We checked with more than just the first ten members on this exclusive club, and also varied the time frame but no materially different picture emerged. We therefore concluded that the observed limited participation of stocks on the NYSE in the continuing rally of the SPY was not a flight to safety in selected large-cap and over-weighted stocks in the S&P 500, or SPY.

The logical next step in our quest was to check the other end of the spectrum and investigate the market sentiment towards stocks with smaller market capitalization in comparison with the overall bull market. The Russell 2000 index represented by the iShares Russell 2000 ETF (NYSEARCA:IWM) is a good proxy for this particular comparison. It includes a broad selection of small-cap and mid-cap companies. Our assumption was, that performance of the IWF provides a convenient measure of sentiment towards this class of investment.

The chart below shows the performance ratio of the Russel 2000 index, or IWM, and the SPY over the past year. An uptrend in this ratio is clearly visible indicating a steady outperformance of small- and mid-cap companies over the larger-cap members of the S&P 500. Note that the blue thin line in this and the next chart represents the 50 day moving average, and the red thin line represents the 200DMA.

In our view this chart supports the view of a steady and increasing appetite for investments in companies with smaller market capitalization. In general terms this implicates an increasing shift towards higher risk, associated with the market expectation of higher rewards. In our interpretation, investor sentiment has been shifting towards a more pronounced risk tolerance with a preference of smaller-cap investment propositions over staple investments like Microsoft or Exxon Mobile (and others in between) during the past 12 months.

This view is further reinforced when considering the SPDR S&P 600 Small Cap ETF (NYSEARCA:SLY) and comparing its performance to its big brother SPY over the past year in a similar fashion. The implied risk-on behavior becomes even more pronounced in this case. While the Russell 2000 index outperformed the SPY by a factor of 1.1 over the past 12 months the S&P 600 Small Cap ETF outperformed the SPY by a factor of 1.12.

How does this observation fit with our observation of fewer and fewer companies on the NYSE participating in the bull market in recent months? It may just be, that as investors have moved funds towards small- and mid-cap companies these investors were fairly indiscriminate in their choices at first, but have become pickier of late.

In our view a picture emerges where over the past 12 months investors have shifted funds towards smaller-cap stocks in an increasing risk-on mentality. However, investors have become more discerning in the past 5 months and fewer companies have been able to benefit from this shift.

A/D line update

Market sentiment and circumstantial observations when checking the news and our watch lists provide important data points for us. However, we like to test our perceptions with hard data in order to check whether they apply just to our small universe, or perhaps also to the general market. The count of companies increasing their performance on the one hand, offset against companies that are decreasing in performance is measured by a particular market indicator called A/D line which we briefly explained in last week's installment.

When we posted the A/D-line last week much uncertainty about ongoings in Washington was palpable; and visible in the chart which was pointing downwards at the time. Below we are offering an update of this chart. We observe that during the past week another higher low has formed. Today the A/D line is already toying with overhead resistance again; for the fourth time, we would like to add.

Quite obviously, market sentiment has surged again in relief when Washington decided to stop behaving like little children defending their portion of a sand box. For now, at least. The tide has kicked in again and has lifted most ships in the aftermath of Thursday's "showdown". This positive sentiment could be expected, and we are currently wondering how far this momentum can go in fueling the bull market and increasing participation of stocks again.

It is worth analyzing the chart of the A/D line below. The purple lines in the chart indicate a wedge forming in the A/D line that is asking for a break in the near-term future. A break to the upside would indicate a return to more indiscriminate risk-on fund distribution. A break to the down side would reinforce warning signs for a market turn-around in the not so distant future.

And what does it mean for Gold?

Well, since gold is still our favorite investment topic, we would like to tag on this final paragraph before calling it quits for this week.

We are afraid that gold as represented by the SPDR Gold Trust ETF (NYSEARCA:GLD) will need to spend some more time in the sin bin. "Sell the rumor" has led to an intra-day low of around $1,252/oz this past week and "buy the fact" has pushed the price back up above $1,300/oz. There would have been a plethora of excuses to turn north for gold recently but they have been ignored. In our interpretation, sentiment towards gold has overshadowed fundamental input and not allowed gold turn bullish again. If GLD could not capitalize on last week's fundamental data, then how can we expect GLD to appreciate in the present atmosphere of stock market relief and political calm?

We would interpret a break to the upside of the aforementioned wedge as a bearish sign for gold and a bullish sign for the general stock market. On the other hand, if the stock market tops out and enters a bear market, then this should eventually prove bullish for gold. However, we would assume an initial period of time where this presumed bear stock market drags gold down with it due to people scrambling to raise liquidity and selling gold holdings in the process.

The observed risk-on market sentiment does certainly not support the near-term performance of gold in its traditional function as a safe-haven. Two factors are working against gold in this respect: firstly, the general risk-on sentiment which we deduct from the observations described above; and secondly, the great volatility in GLD in recent times putting the very safe haven status of GLD in doubt for many investors.

For the moment we assume that GLD trading will be driven by technical considerations and our interpretation of the chart is pointing towards more downwards pressure and a test of the low for the year so far. The market sentiment as it presents itself to us certainly supports this view.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am keeping my powder dry for the moment.