The Market Money Flow: The Yellow Signals Are Flashing

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Includes: DDM, DIA, DOG, DXD, EEH, EEM, EPS, EQL, FEX, GLD, HUSV, IEF, IVV, IWL, IWM, JHML, JKD, JNK, LQD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TLT, TNA, TQQQ, TWM, TWN, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Alex Vasylenko
Summary

After a period of growth, changes in the mood of the market are appearing.

The investors don’t see the prices of the assets far above current levels.

With the possibility of deterioration in the acceptance of risk, appropriate hedging measures should be undertaken.

After the recent sell-off in May, the market rebounded with major U.S. indexes reaching all-time highs.

However, taking a closer look at the current money flows reveals changes in the mood of investors.

Market breadth

The NYSE Composite Index represents 1900 companies that are listed on the NYSE exchange. The broad range of companies from different countries, sectors of the economy and capitalization levels constituting the Index make it a much better indicator of market performance than the narrow Indexes which are more frequently used.

It is important to understand that the capitalized weight structure of the NYSE Composite Index does not require all constituting companies to grow for the Index to rise. There are situations where inflows from a small number of high-cap companies might be enough to keep Index capitalization rising, while the broad range of less capitalized companies can be undergoing a sell-off.

Such an Index structure creates a background for certain manipulations and, as a result, requires scrutiny.

Starting from June, the % of stocks which are trading above the 20-day Simple Moving Average rose along with the Index, indicating healthy market growth, which was supported by inflows into a broad range of companies with different capitalization and sectors.

But starting from July, the performance of the stocks is becoming less favorable. The small-capitalized companies, which constitute the Index, are currently being sold by investors while the high-caps are experiencing inflows, keeping the Index rising.

(Source: NYSE Composite VS % of NYSE Stocks Above 20-Day Moving Average)

The situation might lead to different outcomes which are hard to predict at the current stance, but the following scenarios are necessary to consider:

1. After a period of rising markets, the investors are fixing their profits and looking for sector rotation.

This is a normal market condition when some sectors are overbought. Thus, investors are fixing their profits and looking for other sectors for capital relocation. Such events occur all the time and do not imply significant problems for the market (only a temporary slowdown) and can provide a good opportunity for bottom-picking when companies from other sectors start to experience inflows.

2. Rising risk ahead.

The second situation might be more dangerous as, in cases where smart money sees the rising risks ahead, they strive to get rid of the less-capitalized companies (assumed more riskier) from their portfolio. Thus, in order to receive the best prices for their assets, they sell them in advance without waiting for the prices to go down. So while the Index is growing based on the inflows in high-cap companies, the smart money is selling their small-cap companies at a rapid pace.

Such a situation occurred at the end of 2018 and can work as an example. While the NYSE Index continued to grow, stocks which constituted the index were undergoing a sell-off. NYSE Index

Since the investors sold the less-cap companies from their portfolios and the inflows in the high-cap companies were no longer required to lift the Index capitalization, the NYSE followed the market and dropped.

NYSE Index

It is crucially important to distinguish the sells driven by income fixing/sector rotation and the situation, where smart money starts to sell-off their portfolios based on the upcoming risks in the market, as these situations require different investment actions.

However, the difference between the two situations is not easy to determine at first glance and thus it requires a comprehensive analysis to conduct.

Derivatives

The subdued Put/Call ratio is giving credits to the sector rotation/income fixing-driven sell-off. The demand for hedging assets tends to rise in a period of rising risk in the market, so the low put/call ratio indicator describes the absence in risk perception in the market.

Put / Call Ratio The $SKEW Index, which tracks the demand for out of money-options and reflects investors optimism, is depressed.

The absence of growth in the Index indicates low expectations for the rally to continue as the opposite scenario would see the investors buying the options which are out of money in anticipation of them reaching the strike prices and yielding advanced returns. This is not happening now and can explain the extremely high stock buybacks from the companies.

SKEW Index (Source: SKEW Index)

The Fixed Income Spreads

The Bank of America U.S High Yield CCC or Below Option Adjusted Spread is expanding, giving credence to the rising risk scenario. Such an event appears when investors are getting rid of the bonds with a below investment grade credit rating and pouring money into the U.S government treasuries. This happens when the financial conditions are not supportive enough for taking additional risk in exchange for higher returns.

ICE BofAML US High Yield CCC or Below Option-Adjusted Spread (Source: ICE BofAML US High Yield CCC or Below Option-Adjusted Spread)

The current spread widening amid the recent Fed monetary policy easing efforts is a point of concern. The easing policy is supposed to contribute to improvements in risk acceptance from the market so the investors will start to add the riskiest assets to their portfolios again. But this is not happening now and the reasons for that are points for additional scrutiny of underlying fundamental conditions of the economy.

However, regardless of the situation above, the market is still eager on the corporate sector, although preferring the investment-grade credit rating assets BBB and above.

As evidence, the spreads between BBB and U.S treasuries, as well as AAA and U.S treasuries are narrowing. Hence, investors are pouring money into corporate bonds with investment-grade credit ratings.

ICE BofAML US Corporate BBB Option-Adjusted Spread (Source: ICE BofAML US Corporate BBB Option-Adjusted Spread)

ICE BofAML US Corporate AAA Option-Adjusted Spread

(Source: ICE BofAML US Corporate AAA Option-Adjusted Spread)

The credit spreads are good indicators for assessing market risk acceptance.

In periods opposite to the current, when investors become fully risk-averse, they tend to get rid of corporate sector assets regardless of their credit ratings, relocating capital towards “safe havens” (U.S Gov. treasuries) and so the spread across all credit ratings tends to expand, as it did at the end of 2018, and can be noticed on the graphs.

Conclusion

The current money flow leads me to the conclusion that recent monetary easing efforts from the Fed are well-priced, as the market with 62% probability see 1 more cut in December while the Fed stated 1 cut for 2019. Thus, unlikely this information is relevant enough to keep pushing prices significantly higher above the current levels.

World Interest Rate Probability (Source: World Interest Rate Probability)

As in the opposite case where the market sees prices to rise substantially far above current levels, the $SKEW Index would be in an upward trend, junk bonds spread would show the opposite performance and the less liquid equity assets would outperform the high-cap (less liquid- more volatile, hence higher returns).

This is not happening at the moment, as the Russell 2000 Index, which represents small-cap companies, is lagging far behind the other Indexes with high-cap components.

Chart Data by YCharts

The recent sell-off in equity, the awaken put/call ratio amid a subdued $SKEW index and the expanding junk bonds spread is a yellow signal. The only factors that are different from the end of 2018 are the narrowing spread between investment-grade corporate bonds. Thus, if this factor changes, the situation will turn to the red zone and the 2018 year-end can be repeated.

The obvious fundamental reason for such money flow is poor corporate performance starting from 2019, which stands at the lowest rate since 2016 and below the 5-year average.

(Source: Earnings estimate progression )

While the S&P 500 forward P/E ratio stands significantly above the 10-year average (14.8x).

(Source: S&P 500 Forward 12-Month P/E Ratio:10 years)

This combination is not conducive for advanced risk acceptance from the market in exchange for additional returns.

Investment Implication:

  • The below investment grade and small-cap assets are subject to additional risk and thus, appropriate hedging measures and portfolio relocation should be undertaken towards better credit quality or higher capitalization.
  • Since the corporate sector is still demanded but the market is trading at high valuations, an individual stock selection with an investment-grade credit rating will be an appropriate investment strategy in the period of slowing corporate growth.
  • It is important to monitor the current market breath performance as, in the case of sell-off intensification accompanied by growth in the put/call index ratio, appropriate hedging measures and changes in the portfolio should be undertaken.
  • If the money flow similar to the 2018 year appears, strategic asset relocation towards “safe haven” and cash exposure should be undertaken.

Disclosure: I/we 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.