A Fragile Bull

While I am intermediate-term bullish on stocks, I am also increasingly concerned about the narrowness of market leadership. Market leadership continues to be concentrated in the Magnificent Seven, as the equal-weighted S&P 500, which represents the average stock, lags the index.
 

 

Here is what this means from top-down macro and a chartist’s viewpoints.
 

 

Inequality = Fragility

Inequality is on the rise. Not only can it be seen in market leadership of the Magnificent Seven, but also at a top-down level in the U.S. economy.

Some inequality is desirable to differentiate winners and losers and reward innovators in a capitalist society. Too much inequality, as measured by the Gini coefficient rising above 40, presents headwinds to an economy’s growth outlook. Research from the International Monetary Fund shows that higher inequality tends to retard growth potential. The tipping point seems to be a Gini coefficient of about 40.
 

 

Inequality has been rising in the U.S. for decades and its Gini coefficient is firmly above 40.
 

 

The growth of inequality translates into a heavy reliance on the well-being of high-income households. Most reports indicate a resilient consumer, but the apparent resilience is dependent on the top 20% of households
 

The good news is consumer spending is indicating a high level of resilience, likely supported by the top 20%. On the other hand, a Fortune interview with Moody’s chief economist Mark Zandi reveals a high degree of economic fragility in the middle and lower income groups:

Zandi told Fortune in an exclusive interview that lower-income households are “hanging on by their fingertips financially.” He explained: “They’ve got a job, so that’s why they’re still able to spend and remain engaged in the economy, but increasingly … the grip feels more tenuous because no one’s getting hired. You can sustain that for a while, but you can’t sustain that forever. If the layoffs do pick up, that lower-middle-income group is gonna get nailed—and they have no options, because they really don’t have much in the way of saving.

 

 

 

Rising Risks

This leads me to monitor retail participation (read: capital owning class) in the stock market. That’s because the top 20% own the lion’s share of household equity holdings. As stock prices rise, the economy sees a wealth effect from increased prices.
 

 

The latest readings show that retail demand is at record levels. Retail cash levels are at seven-year lows, and retail investors are all-in on equities. In light of the market’s narrow leadership, the implication is that they are all in on the popular Magnificent Seven and AI-related names.
 

 

We can see the narrowness of the leadership by comparing the progress of the cap-weighted S&P 500 with the S&P 500 Advance-Decline Line (green line) and the NYSE Advance-Decline Line (dotted red line). Even as the S&P 500 grinds upwards, both A-D Lines have been roughly flat, though they did make minor all-time highs. These divergences are indicative of the difference in performance between the largest stocks in the S&P 500 and the rest of the stock market. While such breadth divergences are warnings of impending tops, I am not very concerned as long as the A-D Lines continue to make new highs.
 

 

MarketWatch also reported that retail investors rushed to buy call options to a record level on Friday, October 10, the day of the stock market wipeout on the news of a renewed Sino-American trade war. This level of retail enthusiasm is troubling from a contrarian perspective.
 

 

These circumstances also lead investors to what I dub the “let them eat cake” factor. The dotted red line depicts the share performance of luxury goods maker LVMH compared to Dollar Tree, who serves lower-income segments of the population. This ratio has been on a tear since early August, which coincides with reports of consumer spending resilience.

By contrast, the relative performance of the equal-weighted consumer discretionary to consumer staple stocks (green line) has weakened in the last month, indicating broad economic weakness. Further extensions of the U.S. government shutdown could dent consumer confidence and depress this ratio. I would interpret that outcome as a real-time signal of weakness in the bottom 80% of the consumer and a short-term warning for risk appetite.
 

 

Equally concerning is the elevated NFIB Uncertainty Index. NFIB surveys are useful inasmuch as small businesses have little bargaining power and they are therefore sensitive barometers of the economy. Elevated levels of uncertainty pose a headwind to growth, as businesses will be hesitant to invest and hire during such periods.
 

 

Despite these risks and the fragility of narrow market leadership, the technical condition of the NASDAQ 100, which represents the bulk of the market favourites, remains healthy. The index is rising steadily in a well-defined uptrend, and relative breadth indicators (bottom two panels) are improving.
 

 

From a long-term perspective, the normalized 12-month relative return of the NASDAQ 100 (black line) isn’t stretched. The ratio is in the middle of its historical range even as the relative return ratio (dotted red line) staged a breakout to a fresh high, which gives these stocks more room to run. These are signs of a healthy long-term bull.
 

 

 

Vulnerable to a Correction

In the short run, however, the market is vulnerable to a pullback. The technical breakdown of the NYSE McClellan Summation Index (NYSI) is continuing. Past episodes have signaled pullbacks of differing magnitudes.
 

 

Bullish psychology is showing signs of coming off the boil. The 10 dma of the equity put/call ratio reached a crowded long level and it’s beginning to turn up. Similar episodes have also been signals of market pullbacks in the past.
 

 

As well, the relative performances of defensive sectors are turning up. This is a signal that the bears are trying to take control of the tape.
 

 

In addition, private credit is becoming a source of investor anxiety. In the wake of the collapse of subprime auto lender Tricolor Holdings, followed by the bankruptcy of auto-parts supplier First Brands, JPMorgan Chase CEO Jamie Dimon’s warning about cockroaches in the financial system: “My antenna goes up when things like that happen. And I probably shouldn’t say this, but when you see one cockroach, there are probably more… Everyone should be forewarned on this.” Even before Dimon’s “cockroaches” comment, the BoA Global Fund Manager Survey showed respondents were increasingly concerned about private equity and private credit as a source of systemic credit risk.
 

 

I am monitoring the credit market as a source of tail-risk. The relative price performance of junk bonds against their equivalent duration Treasuries is flashing a warning sign. As well, the price performance of Blue Owl Capital, a manager of alternative investment solutions in private credit, has been weakening.
 

 

In conclusion, the narrow market leadership presents fragility challenges for investors. The economy is becoming increasingly dependent on the top 20% of consumers, and the market is dependent on Magnificent Seven and AI stocks to lead the market. While there are no signs that these trends are about to break, the market is overextended in the short run and can correct at any time. I am seeing emerging signs that a corrective phase may be about to commence.