Something Is Wrong With The U.S. Stock Market

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Includes: AAL, AAPL, AMZN, DAL, DIA, EWJ, FB, GILD, GOOGL, HYG, IBB, JNK, KMI, NFLX, SPY, UNP, USO, XBI
by: William Koldus, CFA, CAIA

Summary

Japan initiates negative interest rates.

Leading stocks are lagging as a group. The biotech bubble has burst.

A rebound in sick sectors like high yield bonds and oil has not spilled into the broader market.

Leading transportation stocks continue to struggle.

Rallies should be sold until the health of the market improves.

"We have tried spending money. We are spending more than we have ever spent before and it does not work...We have never made good on our promise. I say after eight years of this administration we have just as much unemployment as when we started. And an enormous debt to boot!" -- Henry Morgenthau in 1939

Introduction

In my last overview of the market, titled, "When The Stock Market Bounces, Rallies Should Be Sold," I articulated why the steepness of the recent sell-off was suggestive of a future bounce. While the tone of this piece was more bullish over the short-term timeframe than the last two articles covering the broader markets I authored, it still was cautious on return prospects for investors. Central bankers apparently feel the same way, as Japan's central bank introduced negative interest rates, joining the list of countries that are going the opposite way of Fed tightening. How soon till the Fed reverses course? Adding to the selling pressure, leading momentum stocks have struggled as a group, with biotech stocks recently trading at new 52-week lows. Additionally, several out-of-favor sectors, including oil and high yield bonds, have tried to put in a bottom, but the broader markets have continued to struggle, tell-tale signs of something wrong under the surface.

Thesis

While a bounce should be expected given the magnitude of the recent sell-off, the U.S. stock market remains unhealthy, and rallies should be sold.

Japan Initiates Negative Interest Rates

While the Dow Jones Industrial Average (NYSEARCA:DIA) had its worst start to the year ever, and the S&P 500 Index, as measured by the SPDR S&P 500 ETF (NYSEARCA:SPY), has been weighed down by Apple Computer (NASDAQ:AAPL), its largest holding, global developed equity markets have experienced their own material declines over the past year. Focusing on Japan, the iShares MSCI Japan ETF (NYSEARCA:EWJ) retreated more than 20% from its 2015 high to approach its 2014 lows.

With global equity markets in the midst of a renewed push down, the Bank of Japan decided to preemptively act, taking interest rates into negative territory, further bolstering perhaps the world's most aggressive central bank policy, which already includes directly buying equities via ETF's.

From the above linked Bloomberg article, comes the following chart, which shows that Japan's central bank now owns over 50% of the entire Japanese ETF market.

Click to enlarge

Take a look at the above chart again, and imagine how much further central banks around the world could go to stimulate asset prices. The size and scope of the BOJ's asset purchases are simply breathtaking and unimaginable prior to the 2008/2009 downturn.

Leading Stocks Continue To Struggle

As I am writing this article, Amazon (NASDAQ:AMZN) is trading sharply down in pre-market trading. Since hitting an all-time high of near $700 per share in the fall of 2015, shares have retreated sharply as shown in the chart below:

Netflix (NASDAQ:NFLX) has also come under selling pressure, despite posting robust subscriber additions in its quarterly earnings announcement.

Alphabet (NASDAQ:GOOGL) has held up better than AMZN and NFLX, but the clear star of the FANG stocks has been Facebook (NASDAQ:FB), which is near its all-time high (second chart).

The Biotech Bubble Has Burst

One leading area of the market that I warned about last year was biotech stocks. After experiencing extreme volatility during the August 2015 sell-off, biotech shares, as measured by iShares Biotech ETF (NASDAQ:IBB), and the SPDR S&P Biotech Index ETF (NYSEARCA:XBI) have sold off, sharply undercutting their previous 2015 lows.

Even seemingly stronger biotech blue-chips, like Gilead Sciences (NASDAQ:GILD), which I authored an article suggesting a pair trade between fundamentally superior GILD and IBB, have been impacted by the flood of capital out of the sector.

Oil and High Yield Bonds Rally

The sell-off in oil prices over the past several months, as measured by the United States Oil Fund (NYSEARCA:USO) has correlated almost one to one with the sell-off in high-yield bonds, as measured by the iShares iBoxx High Yield Corporate Bond Fund (NYSEARCA:HYG), and by the SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK). Oil prices have rallied over the past several days, putting a bid under high-yield bonds as illustrated in the following charts.

As energy has rallied, some of the beleaguered energy stocks, like Kinder Morgan (NYSE:KMI), have staged their own bounce.

Suspiciously, the broader market has not responded thus far to the rally in energy and high yield bonds.

Transportation Stocks Continue To Struggle

Another troubling sign for the market is that leading transportation stocks like Union Pacific (NYSE:UNP), American Airlines (NASDAQ:AAL), and Delta Airlines (NYSE:DAL) have not reacted positively to lower oil and fuel prices. In fact, these stocks, which led the decline in the broader market, continue to hover near their 52-week lows.

The inability of railroads and airlines to rally on significantly lower fuel prices is problematic. Additionally, weakness in transportation stocks is a leading indicator of weakness in the broader markets and in the economy.

Conclusion - Keep The Defensive Team On The Field

After a brutal sell-off to begin 2015, the broader U.S. stock market is due for a technical bounce, much like the recent bounce in oil prices. Notwithstanding an oversold rally, even a powerful one, there are many cracks in the foundation of the stock market, signifying sickness, not health. The price action in Treasury bond prices, as measured by the iShares Barclays 20+ Year Treasury Bond Fund, illustrates this setting, as prices are rising, meaning yields are dropping.

Large institutional investors, like hedge funds, are liquidating, as investors pull the most money from hedge funds since 2008, providing a perilous back drop for individual investors. Until the "health" of the market improves, rallies should be sold. The only "dip buying" that should occur, in my opinion, should be in companies and sectors that have been out-of-favor for years. To close, keep the defensive team on the field, and look for opportunities in value stocks.

Disclaimer: Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I am/we are long AAL, UNP, KMI, SHORT SPY.

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: Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.