TradingEdge for Dec 17 - Big Tech divergences, Staple thrust, Biotech oversold, bond pessimism

Jason Goepfert
2021-12-17
This week, we saw a continued negative divergence in many tech stocks in the Nasdaq 100. Defensive sectors like Consumer Staples is seeing the opposite scenario, with a recent breadth thrust. Biotech looks oversold. Overseas markets continue to struggle versus the U.S. Sentiment on bonds is trying to recover from a near decade-low.

Key points:

  • There has been a protracted negative divergence between the Nasdaq 100 and most of its stocks
  • We see the opposite scenario in some defensive sectors like Consumer Staples
  • Breadth metrics show Biotechnology stocks may be washed out
  • The U.S. is still the place to be as overseas markets struggle
  • Gold stocks are entering a golden seasonal window
  • Sentiment on bonds plunged in November and is trying to recover
  • Simple, long-term trend-following methods point to lower yields

Tech's participation problem

Last week, we saw an impressive thrust in buying interest among a broad swath of stocks. That kind of behavior has been almost universally positive for future returns, and those are among the most consistent signals we study.

Not all is hunky-dory. Among the primary drivers of sentiment has been the resilience of American Big Tech, and many of them are stumbling. Not the companies that grab all the headlines; it's the smaller stocks that make up the rest of the Nasdaq 100 (NDX).

Within the NDX, there has been a protracted divergence that's getting more profound. Fewer than 65% of NDX stocks are currently trading above their 200-day moving averages. That is a stark change from a year ago when internal trends improved as the NDX marched steadily higher. The index is still doing its thing, but there have been fewer and fewer participants on each successive peak since the summer.

When we zoom out over the past 20 years, we can see that there have been 4 relatively similar periods. All preceded a tough market for the index over the next year or so.

Within the past 30 sessions, there have been 7 days when the NDX was within 1.5% of high, yet fewer than two-thirds of its stocks were trading above their 200-day averages. Between 3-6 months later, the NDX showed a negative return after 7 of the 8 signals. Only the signal from late 2017 managed to escape much trouble, though those gains were ultimately (and temporarily) erased.

While breadth thrusts are among the most consistent signals, divergences are among the least consistent - especially in 2021. So, we'd tend to place more weight on the positive signs recorded last week than the negative ones in specific sectors, including many of the tech stocks in the Nasdaq 100. 

When sentiment reached a speculative excess by the beginning of November, it suggested that riskier parts of the market were most vulnerable to a pullback. We see some of that in the poor performance among many members of the NDX. A few gigantic companies, perceived as safe havens, have been able to keep the index afloat. But if history is any guide here, the drag of many of the other stocks will help keep a lid on significant, sustained gains.

Some broader issues

Dean noted that a new warning signal from a voting member in the TCTM Risk Warning Model registered an alert on Tuesday. The new 52-week high low ratio model identifies when NYSE 52-week lows exceed 52-week highs by a ratio of 1.5 or greater. At the same time, the S&P 500 index is two days or less from a 252-day high.

This signal triggered 38 other times over the past 93 years. After the others, future returns and win rates were weak in the 2-8 week time frame. The z-score in the 2-week time frame looks troubling.

Dean mentioned some caveats, however...

  1. While several TCTM Risk Warning Model components have issued an alert highlighting an unhealthy breadth environment, I would keep the following in mind. Financials are not dominating the new lows list. That's an important distinction from other periods when the risk warning model issued alerts. Financials are the most systemically important group to monitor. If the financials are out of sync with the broad market, we need to be more attentive to potential unforeseen risks.
  2. We continue to see a mixed message from breadth-based indicators. However, the economic backdrop, credit conditions, and primary trend of the S&P 500 look fine. So, it's conceivable that the S&P 500 continues to consolidate in a range, with conflicting messages in both directions. 

Consumer Staples are seeing the opposite behavior

While breadth in more speculative areas is struggling, it most certainly isn't among more defensive names. On Monday, we saw how internals on the Nasdaq 100 are lagging the index. Broader breadth has been pretty good, even thrusty, and that's thanks to other sectors like Consumer Staples.

Heading into this week, there was a massive and sudden shift in short-term trends in Staples. Within a little over a week, fewer than 5% of stocks in the sector were trading above their 10-day moving averages, and then every single one of them was.

Even though it's a shorter-term gauge, we've seen that quick shifts suggest a reliable change in sentiment in prior years. That has been the case for Staples as well. Out of 15 signals, there were few losses after a month and beyond.

Looking at the Risk/Reward Table, only 1 of them showed more risk than reward during the following year; the others were heavily skewed to "reward."

The short-term reversals in many stocks have helped push the long-term McClellan Summation Index for Staples above +500 for the first time in more than 6 months. In recent years, a move above +500 was the kick-off before significant, sustained gains in the sector.

Other indicators are positive for Staples as well, like relatively high correlation among the stocks, and corporate insider selling pressure that just fell to the lowest level in over a decade.

From a broader market perspective, it's curious that we see negative thrusts and divergences in higher-risk areas like the Nasdaq 100 and the opposite in defensive sectors like Consumer Staples. That's not a big vote of confidence in stocks in aggregate.

For Staples themselves, this kind of activity has been a good sign for the medium- to long-term. Staples have a poor seasonal window during January-February, and other indicators are mostly neutral. But the combination of a positive short-term thrust under the surface, improving long-term internal momentum, and a lack of insider selling suggests higher prices.

Bio-tech turned into a bio-wreck

Heading into February's speculative peak, almost everything was in gear. That euphoric sentiment eased as some of the riskiest parts of the markets took a dive or treaded water at best.

Since then, there have been entire sectors that have lagged the broader market. Some equity indexes, especially those weighted by market capitalization, are at or near record highs. But not everyone is enjoying the gains - Biotechnology stocks have been hammered.

There is some evidence that the selling pressure is overdone. At the recent low:

  1. Fewer than 10% of these stocks traded above their 10-day moving averages. That ranks in the bottom 2% of all days since 1999.
  2. Fewer than 15% of them traded above their 50-day averages, ranking in the bottom 3% of all days.
  3. Fewer than 20% of them held above their long-term 200-day moving averages, in the bottom 4% of all days.
  4. Fewer than 10% of Biotech stocks were able to hold within 20% of their 52-week highs, ranking in the bottom 1% of all days in the past 22 years.
  5. Fewer than 20% of the stocks outperformed a broad Biotech index, ranking in the bottom 1% of all days.
  6. The median stock in this sector got hammered, with a drawdown of more than 50% from its 52-week high. That's in the bottom 2% of all readings.

Combining all these metrics into a composite, it recently dipped below 20%, recording a level of oversold behavior in the bottom 1% of all days.

Biotech stocks are a tough group for traders and even tougher for investors. They can go years with little reward, punctuated by the occasional panic due to a regulatory move or alarming study outcome. Despite a year of miraculous advances, many of these stocks have not only been overlooked but sold aggressively. 

The selling pressure heading into this week was on par with some of the worst internal declines in 22 years. While it's always a risk to rely only on historical precedents, especially in the shorter term (witness Chinese tech stocks), there is some decent evidence that long-term returns in the sector should be positive.

U.S. is *still* the place to be

Dean updated a look at absolute and relative trends in industry, sector, and country ETFs.

The percentage of countries with a positive relative trend score versus the S&P 500 declined to the lowest level since July. When country ETFs underperform to this extent, annualized returns for a broad-based global equity allocation are unfavorable. 

The percentage of countries with a relative trend score of -10 increased to the highest level since May 2020. Foward returns look extremely unfavorable when so many have such negative trends.

An in-depth look at where investors are focusing in sectors shows a handful of groups are driving S&P 500 performance with technology providing the most significant attribution.

Strength is primarily evident in the U.S., with overseas indexes showing an alarming level of relative underperformance. When trends were lagging like this in the past, annualized returns in the MSCI indexes have been poor.

Gold stocks' golden window

Most of us are aware that stocks have a seasonal tailwind around this time of year. Less known, according to Jay, is that gold-related stocks have enjoyed consistent gains, as well.

As a proxy, we will use the Fidelity Select Gold fund (FSAGX). Per Fidelity:

Investing primarily in companies engaged in exploration, mining, processing, or dealing in gold, or to a lesser degree, in silver, platinum, diamonds, or other precious metals and minerals. Normally investing at least 80% of assets in securities of companies principally engaged in gold-related activities, and in gold bullion or coins.

The period in question begins on the close of the 11th trading day of December and extends through the close on the first trading day of January in the New Year. For 2021 this period extends from the close on 12/15/2021 through the close on 1/4/2022.

The chart below shows the cumulative growth in FSAGX only during these seasonal windows since 2000.

When we look at the year-by-year results, we can see that 30 out of 33 years were winners or flat, with the losses being relative small compared to the average gain. The last 14 years were all winners.

Bond sentiment recovering from near decade-low

Investors ditched bonds a few weeks ago, and now they're gingerly coming back.

The Optimism Index (Optix) for bonds plunged to 25% in late November. Since then, it has rebounded and not set another low, raising the possibility that sentiment has troughed.

That heavy pessimism from before Thanksgiving was in the bottom 2% of all days in the past 30 years.

Let's make the assumption that not setting a lower low in sentiment for 15 consecutive days, after recording a reading below 30%, suggests that investors have finished panicking. Then we can see if that improved forward returns. For 10-year Treasury futures, it did, but only modestly.

The problem was multiple false positives during a couple of big drops in bonds in the mid-and late-1990s. When we switch to the TLT fund, returns were excellent in large part because it avoided those ugly episodes.

Looking at some other measures of sentiment toward bonds, a 50-day average of the put/call ratio on 10-year Treasury futures just ticked up to an all-time high. At the same time, "smart money" commercial hedgers are holding more than 14% of open interest in 10-year Treasury futures net long, among their most significant exposures ever.

Surveys show little appetite for bonds. Individual investors are holding nearly a decade-low exposure to bonds at 14.4% of their portfolios. Similarly, U.S. consumers are pessimistic on bonds. More than 62% of consumers expect interest rates to rise (bond prices fall), while only 11% expect rates to drop (bond prices rise). 

None of these are perfect but generally precede rising bond prices after similar readings. The biggest challenge, as usual, is whether the environment we face now is anything like any other period in history, much less just the past 30 years.

Trend-following in interest rates

Jay looked at a couple of long-term trend-following methods for interest rates.

The chart below showsthe month-end yield for 10-year treasury notes since 1913 minus its 120-month exponential moving average. This value fluctuates above and below 0. When the reading is above 0 it implies that interest rates are in an uptrend, and when the reading is below 0, it implies that interest rates are in a downtrend. The good thing about interest rate trends is that they tend to persist for a very long period of time.

To measure the efficiency of this simple method for tracking interest rates, let's use the following methodology:

  • Add changes in yield points if the 10-year yield is ABOVE its 120-month EMA
  • Subtract changes in yield points if the 10-year yield is ABOVE its 120-month EMA

The chart below shows the cumulative yield points captured using the 120-month EMA method since 1926.

Jay also noted that small-cap stocks can be more sensitive to economic conditions. So, it makes some sense that when those stocks are outperforming, bond yields tend to rise.

To identify the trend for this test, he used a 2-month and a 7-month exponential moving average (EMA) of the small-cap/large-cap ratio at the end of each month. 

To measure the efficiency of this simple method for tracking interest rates, let's use the following methodology:

  • Add changes in yield points if the small-cap/large-cap 2-month EMA is above the 7-month EMA
  • Subtract changes in yield points if the small-cap/large-cap 2-month EMA is below the 7-month EMA

The chart below displays the cumulative yield points captured using this method since 1926.

The ebb and flow between small-cap and large-cap stocks have demonstrated a high degree of correlation with the fluctuations of interest rates over the past 95 years. Tracking this relationship as described above can help an investor stay in tune with the primary interest rate trend and filter out a lot of the "noise" generated on the topic.

As of the end of November 2021, this monthly indicator was negative and thus suggesting lower interest rates.

About the Weekly Wrap...

The goal of the Weekly Wrap is to summarize our recent research. Some of it includes premium content (underlined links), but we're highlighting the key focus of the research for all. Sometimes there is a lot to digest, with this summary meant to highlight the highest conviction ideas we discussed. Tags will show any symbols and time frames related to the research.

Sorry, you don't have access to this report

Upgrade your subscription plan to get access