With the end of the Federal Reserve’s Treasury purchase program QE2, the stock market has lost an important source of liquidity as we head into the second half of the year. Although the 6-year cycle is still peaking into the early October time frame, there are some important leading indicators that warn us to be concerned about the stock market’s intermediate-term outlook beyond the month of July.
The two most glaring indicators are the negative divergences visible in both the Broker/Dealer Index (XBD) and the Bank Index (BKX). The bank and broker/dealer stocks are important to watch since they are extremely sensitive to changes in monetary policy as well as demand for equities. It’s not uncommon for the financial sector stocks to lead the broad market lower several weeks or even months in advance of a bear market.
The most recent instance of this occurring was the April-June correction, as the bank stocks peaked out in mid-February and commenced a decline even as the broad market S&P 500 Index (SPX) was making new highs into the beginning of May. The XBD peaked out in February as well as both the bank stock group and the broker/dealer stocks telegraphed a danger signal to investors. The SPX reversed after making a final high for the year on May 2, and the index has been below this high ever since.
Below is a year-to-date chart of the S&P 500 compared with the BKX and the Broker/Dealer Index, XBD. You’ll note the conspicuous lag in both financially sensitive stock indices compared with the broad market SPX price line. The last time we saw such a notable divergence like this in the XBD and BKX was back in 2007, in the months leading into the debt crisis.
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The debt crisis was never formally resolved but was merely delayed through the combined efforts of the developed world’s central banks. The financial market was fed a steady stream of liquidity to address one of the symptoms of the crisis while the underlying causes (namely debt and insolvency) were essentially ignored. This means we can expect a return of the debt crisis in full force at some point before all is said and done, likely well before the Kress 120-year cycle bottoms in 2014.
The latest facet of the international debt crisis can be seen in the media’s fixation of the Greek debt problem as it relates to the European Monetary Union. There are fears of a European contagion should Greek default on its debt, as well as fears of how Wall Street would react to such an event. In a bull market where the leading indicators are all confirming a strong, healthy market we might dismiss such fears as being a contrarian sign that the stock market’s “wall of worry” is alive and well. But experience teaches that it isn’t wise to lightly dismiss headline fears when the indicators are in decline and the internal path of least resistance for stocks is down. Such was the case in the better part of 2007, and 2008, as headline fears spooked the market on several occasions.
Until the leading indicators show substantial improvement, investors might want to consider exercising caution and avoiding overexposure to equities.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.