Think of "market internals" as the blood pressure and insulin levels of the
financial world. They operate below the surface, frequently unnoticed, but
over time they have a big say in the health of the patient.
And right now they're pointing to a heart attack.
Let's start with junk bonds. These are loans to financially and/or operationally-weak
companies that because of their weakness have to pay up to borrow. Such bonds
have a risk/return profile that's more akin to equities than to, say Treasury
bonds, and they trade accordingly, rising and falling on the likelihood of
default rather than their relative yield.
Recession means higher default rates for weak borrowers, so when the economy
is slowing down or otherwise hitting a rough patch, the junk bond market is
often where it registers first. Lately, junk has been tanking relative to stocks
(chart created by Hussman
Funds):
Another widely-followed internal is the relationship between large-cap (i.e.,
relatively safe) stocks and riskier small caps. When large caps outperform
small caps, it's frequently a sign that the broader economy is weakening. Since
September, that's been happening too:
In general, when market leadership gets extremely narrow - that is, when only
a few things are going up and everything else is either flat or falling - trouble
ensues. During the late 1990s tech stock mania, for instance, the global economy
ended up being supported by the US, whose economy was supported mostly by the
NASDAQ, which was supported by just a handful of high-flying tech stocks. When
those stocks finally cracked, they took the whole world down with them.
Now something similar is happening, thanks in large part to this cycle's dominant
tech firms, especially Apple. From CNBC:
The
days of Apple's amazing profits may be over
The S&P 500's profit margin growth over the past five years has been
driven largely by tech, and one name in particular: Apple. Unfortunately
for the market and for Apple, the days of exceptional expansion may be over.
That's according to David Kostin of Goldman Sachs, who wrote in a note Monday
to clients that he expects margins to remain flat at 9.1 percent for 2016
and 2017.
"Many of the drivers of margin expansion during the past few decades appear
to be behind us," Kostin wrote, listing former catalysts such as lower interest
rates, lower taxes, a switch from manufacturing to services and technological
innovations.
Since 2009, information technology has been responsible for about 48 percent
of overall S&P 500 margin expansion. Apple alone has been responsible
for 18 percent. [But that is about to change.] According to BK Asset Management's
Boris Schlossberg, Apple's "lack of gusto" when it comes to profit margins
is a result of unsatisfactory products, aside from the new iPhone.
"At this point, the watch is a bust, TV is a bust, the big iPad is not really
flying off the shelves," Schlossberg said Tuesday on CNBC's "Trading Nation." "I
don't see any other place where they're going to be able to get the kind
of margin expansion that they've been able to get for the last five years."
And while Apple is up 7 percent for the year, Schlossberg said investors
may be losing enthusiasm for the stock as well, at least compared with other
tech outperformers this year.
To summarize, Apple will remain a great company but won't continue to make
more on each new dollar of sales. And this will cause investors to start treating
it like a non-deity, revaluing its stock accordingly.
Meanwhile there's a good chance that Apple will soon fall victim to a combination
of falling tech prices and rising quality. Low-end consumer electronics are
now adequate for most people, leaving the average consumer far less anxious
to buy the best. Today there are 70-inch flat-screen TVs with a great picture
to be had for $1,000 or less. Low-end smart phones, meanwhile, can now do most
of what the best iPhone could do just a few years ago. A friend recently bought
an $80 Windows-based phone that he describes as "okay.pretty good screen and
it texts just fine." He pays about $25 less per month than with his old, much
more expensive phone, and is happy with the trade-off. Barring a new must-have
iPhone killer app, this trade-off is only going to become more compelling going
forward.
So what happens to a market that's balanced precariously atop the shares of
a handful of "must own" companies when those companies lose their halos? Historically,
the previously-strong sectors join the rest in a broad sell-off.
