How Bad Is The Leak?

Includes: EEM, JNK
by: Clif Droke

U.S. equity market has developed a "leak" in recent weeks.

Industrials and financials are the main areas of culprits.

Leak isn't bad enough to threaten longer-term bull market, however.

In the last half of June a leak developed in the NYSE broad market. At first this "leak" was observable only by looking below the surface at a few market segments, most notably the industrials and the financial stocks. In recent days this leak has increased in size and now encompasses even elements of the tech sector, which had shown surprising relative strength in recent months. In today's report we'll see just how bad this leak is and whether or not it will continue to worsen. As the evidence suggests, the leak will likely be contained this summer without threatening the longer-term bull market.

Despite a positive finish for the major averages on Friday, the market finished with a net loss for the last week of June. The benchmark S&P 500 Index (SPX) finished with a gain for the month, but not by much. Meanwhile the Dow Jones Industrial Average (DJIA) finished slightly lower for June. In the intermediate-term (3-6 month) scheme of things the stock market remains range-bound and has made no progress since February, as the DJIA graph suggests.

Dow Jones Industrial Average

Source: BigCharts

One of the biggest contributors to this lack of forward progress is the spillover weakness the emerging markets have exerted upon the U.S. equity market. The following graph of the iShares MSCI Emerging Markets ETF (EEM) provides a visual highlight of the downward trajectory of emerging market stocks since February. This weakness has been exacerbated by the tariff war between the U.S. and China, as a recent Barron's article points out. The mere threat of tariffs can act as a drag on growth on both sides of the Pacific, as the article suggests.

iShares MSCI Emerging Markets ETF

Source: BigCharts

The trade policy threat to global economic growth has evidently been factored into the EEM price. The trend in the emerging markets ETF in turn has often served as a leading indicator of weakness for the U.S. equity market due to U.S. industry's interconnectedness to the emerging markets. Thus as long as EEM continues its downward path, U.S. stock investors should remain defensive due to the potential for propinquity damage.

Aside from the ongoing weakness among industrial stocks, the financial stocks have had their own struggles of late. Although financials led the market higher out of the gate last Friday after the Fed cleared most big banks to increase their dividends and share buybacks, the heavily-weighted sector faded as the day went along, entirely retracing a gain of 1.8% and ending lower by 0.1%. This shows just how much overhead resistance the big bank and broker/dealer stocks have been contending with.

The NYSE Arca Securities Broker/Dealer Index (XBD) chart has established a series of lower highs and lows since May and is conspicuously under-performing the benchmark S&P 500 (SPX). Broker/dealer stocks are quite sensitive to shifts in the winds which govern the near-term direction of the broad market, so until XBD reverses its downward slope investors should remain on the defensive and refrain from not only purchasing new positions in the financial sector, but in other sectors as well.

NYSE Arca Securities Broker/Dealer Index

Source: BigCharts

Another factor which investors should closely monitor in the coming weeks is the developing weakness in the junk bond market. Seeking Alpha reports that the yield on the Bloomberg Barclays US jumped to its highest since December 2016, with surging issuance and big fund outflows. Meanwhile reports that the SPDR Bloomberg Barclays High Yield Bond ETF (NYSEARCA:JNK) saw 20,000,000 units destroyed last week, a nearly 7% decrease week over week.

This weakness can be discerned by observing the recent progression of the SPDR Bloomberg Barclays High Yield Bond ETF (JNK), which can be used as a proxy for junk bond prices. As the graph shows, junk bonds have sustained some selling pressure in recent days, with JNK closing at its lowest level of 2018 on Jun. 29 and hitting a new 52-week low in the process.

SPDR Bloomberg Barclays High Yield Bond ETF

Source: BigCharts

A sustained decline in the JNK can indeed become a flash point for a major sell-off in the U.S. equity market, as it did in 2015. However, the lag time between a major and sustained decline in JNK and a serious sell-off in the Dow and SPX can be several months. Therefore I don't put too much weight on the latest weakness visible in JNK. A continuation of the JNK's decline in the next few weeks, however, would definitely be a cause for concern of the overall health of the U.S. equity bull market.

The "tape" for the U.S. broad market remains weak on an immediate-term (1-4 week) basis, however. This is proven by virtue of the fact that stock making new 52-week lows on both major exchanges continue to outpace new 52-week highs. Until this dynamic shifts and the number of NYSE- and Nasdaq-listed stocks making new lows falls below 40 for a few days, investors should continue to assume that the sellers still control the immediate-term outlook. Accordingly, as long as 52-week lows are above 40 on most days and the 4-week rate of change (momentum) of the new highs and lows is trending lower - as shown in the chart below - the stock market will remain vulnerable to news-related selling pressure.

Source: WSJ

In view of these factors, investors should continue to maintain a cautious stance and refrain from initiating new long positions in NYSE stocks right now. Although the "leak" which has developed in the equity market as a result of the emerging markets plunge and tariff war is serious enough to warrant defensive action, it's not big enough to threaten the long-term upward trend in U.S. stock prices. As the following graph suggests, forward earnings for the S&P SmallCaps, MidCaps, and LargeCaps continue to trend impressively higher, suggesting that the bull market remains on a firm footing. Forward revenues estimates and profit margins for the S&P 500 also continued to climb to record highs in June, as Dr. Ed Yardeni highlighted in a recent blog.

S&P 400/500/600 Forward Earnings

Source: Yardeni Research

Until the short-term internal weakness discussed above has diminished, however, investors should remain on the defensive and also take advantage of the current environment to prune their portfolios by trimming losses among under-performing large cap stocks, raising stops on all long positions, and taking some profits on winners.

Disclosure: I am/we are long XLK, IYR. 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.