Market internals deteriorated sharply last week, following an extended period of overvalued, overbought, overbullish conditions where interest-sensitive sectors have been under considerable pressure. At present, the line of least resistance appears downward. That will change. It may change quickly, and while we haven’t seen a material retreat in valuations, a firming of market internals even here might support a somewhat more constructive outlook. Still, investors should also recognize that the sequence of conditions we’ve observed – strenuous overvalued, overbought, overbullish conditions, followed by distinct weakness of interest-sensitive sectors (Treasury bonds, corporates, utilities), broadening internal dispersion and reversals in leadership (new highs/lows) and breadth (advances/declines) on both longer-term and high-frequency measures (e.g. another Hindenburg on Wednesday) – these are conditions that have historically preceded panics and crashes. They are indicative of a shift from risk-seeking to risk-aversion.
Make no mistake, last week’s decline was not because of a hawkish Federal Reserve, but in spite of a dovish one. On Wednesday, Ben Bernanke essentially promised that the Fed would continue to expand the size of a balance sheet that is already leveraged nearly 60-to-1 against its capital, regardless of market distortions. Though the Fed might possibly reduce the rate at which it expands that position, Bernanke indicated that the Fed will not stop adding to it until at least 2014 (stopping only on the basis of economic improvement that we view as implausible). Anyone who understands the relationship between short-term interest rates and the amount of monetary base per dollar of nominal GDP also understands that Bernanke has promised that short-term interest rates will be repressed as far as the eye can see. There was no talk of risks. Not a whisper about diminishing benefits. No – Bernanke came in full-metal dove. Perhaps shaken by the market reaction on Wednesday afternoon and Thursday, Bernanke evidently dispatched the Wall Street Journal’s Jon Hilsenrath to suggest that the markets were ignoring all those dovish signals from the Fed.
In short, the only thing that happened with Fed policy last week was that Bernanke reiterated a dovish stance. While QEternity will become QEventualTaper, the Bernanke Fed does not actually contemplate stopping until the unemployment rate comes down, even though that objective is almost entirely detached from Fed policy itself. Investors who believe that “QE makes stocks go up” – with no other condition required – just got a handwritten, perfumed note from Bernanke to keep buying.
The fact that we are instead seeing broad internal deterioration here is of some concern, because it smacks of something more afoot. It might be the increasing credit strains in China. It may be growing expectations for disappointing earnings preannouncements. It may be economic weakness that finally catches up to the general (though not uniform) deterioration that we’ve seen across leading measures of economic activity. My own litany of concerns is well-known (see Closing Arguments – Nothing Further, Your Honor). But whatever the reason, investors appear to be shifting from risk-seeking to risk-aversion.