A Panoply of Positive Divergences

Bull markets in stocks tend to rise in the face of a wall of worry. For years we have been hearing about this overvalued stock market – it’s lasted too long, risen too far, printing money will lead to inflation, margin debt is too high… we are mirroring the tech bubble of the 1990’s. The excuses are endless. Fact is the Global tech sector has a price to earnings (PE) valuation of 50 at the March 2000 peak and today the roaring global tech index is just 18 with a 16% earnings growth rate forecast in 2017. 

Today there are many generals leading the charge beyond US shores. German, French and British indices are marching to new highs repeatedly in recent months while our Blue Chip S&P 500 and Dow stall. European and most global indexes are behaving like our tech heavy NASDAQ (QQQ).

While Chinese stocks are in line with US trends, Japanese stocks have surged to new highs this past month as optimism over exports to Europe grow.

While Brazilian political scandals have hurt recently, the small Emerging Market stock index has risen another 10% since March, while US stocks congest. We regard the out-performance by European, Japanese, Korean and Emerging stock indices over US stocks as a positive divergence.

We often look for trouble in the US when there is a negative divergence of High Yield Junk Bonds with US stocks (S&P 500). After a minor yellow flag in early May, Junk Bond prices have edged to new highs ahead of US stocks in a modest “positive divergence”, thanks to Oil.  Healthy Oil price trends positively correlate with the pricing of High Yield Bonds. With OPEC and Russia widely expected to agree on May 25th to an alleged supply cut extension into 2018, it’s likely Oil prices and stocks will hold up until the 25th and then pull back short term.

One of the few areas of concern is the sharp negative divergence of small cap stocks compared to benchmark US and Global Indices. The Russell 2000 small cap stocks led the charge on a wave of optimism back in November/December after Trump was elected. The growing doubt over Trump’s ability to pass any stimulus legislation in 2017 has knocked much of the excess premium from this group. Large Cap – Blue Chip companies and tech can excel in a slow growth environment, but smaller companies needs the “old normal” 3%+ GDP growth to utilize their excess capacity and increase margins. While this under-performance may continue for months awaiting the fading promises of stimulus packages – tax cuts, repatriation and infrastructure bills – any sign that the Russell small cap world is hitting new highs would certainly add fuel to the fire.

Since Trump was elected and stocks catapulted higher, sentiment has been somewhat neutral, but not necessarily boring to observe. AAII is said to measure the sentiment of small individual stock investors. As you can see from the chart below, when the Bull minus Bear sentiment spread falls to extremes, it’s typically an excellent time to buy stock. Such extremes may only occur a handful of times a decade. The last clear buy zone was triggered near the major lows in January and February 2016.

Zooming into just the Bullish sentiment data we can again see the extreme oversold sentiment areas at which stock prices bottomed in early 2016. Readers will recall that we used the sentiment data to conclude throughout December to February that investors could keep buying without fear of a deep correction or even a 3% hiccup as sideline money would become increasingly anxious to buy every minor dip. Bullish sentiment did rise briefly after Trump was elected last November 8th, but the rally was so explosive that money managers and small investors alike missed the boat, neutralizing the sentiment. What has been interesting for us has been the steady rise in skepticism as stock prices continued hitting record highs. Amazingly there are about as many AAII Bulls today as there were at the height of uncertainty just prior to the 2016 Presidential election.

As long as global stock indices and junk bonds keep hitting new highs and sentiment remains subdued, we would favor an upside breakout in US blue chip stock indices (S&P 500 and Dow). The way sentiment is behaving we would expect even more extreme negative sentiment to pop up if stock prices have a minor correction in late May and June.

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