Newsletter of Danny Merkel - Issue #142
Market Review:
Let’s begin with the most optimistic view of the market and then work our way down.
The QQQ bulls scored a victory this week by ending the short-term downtrend.
This victory is evidenced by the higher-high (HH) that was printed on Friday or by the fact the 20 & 50 moving averages have crossed back up (shaded circle).
Similarly, the S&P 500 bulls won the battle at an important juncture, clearing the way for a new higher-high and breaking through gap-resistance.
This new short-term uptrend joins the pre-existing long-term uptrend that has been in existence since April (dashed vertical line). Overall, this chart appears constructive.
But there still remains a colossal problem with the overall market and that lies in every stock outside of the S&P 500.
Trading under the symbol VXF, the Vanguard Extended Market ETF tracks every liquid stock in America except for those in the S&P 500.
Because this ETF contains 3,668 stocks, one simply cannot write it off. For the vast majority of stocks in the United States, the bull market doesn’t exist
Perhaps counter-intuitively, even as VXF has bounced this month, the long-term trend has swung back to the down position, which ends the previous (very weak) uptrend.
So we have a tale of two markets, the strong S&P 500 on the one hand and the thousands of weak stocks on the other.
But are the 500 stocks in the S&P 500 truly doing well this year?
Here’s a fact that might surprise you. The average stock in the S&P 500 is down year-to-date.
As the chart below shows, there is an ever expanding divergence growing between large and small stocks:
Given that the S&P 500 is up YTD and given that the average stock within the index is negative YTD, it stands to reason that 100% of the gains this year have been driven by a handful of big-tech names.
This is the biggest divergence I’ve seen in my trading career and it’s being fuelled by a ballooning concentration in fewer and fewer stocks.
As of today, just two stocks - Apple and Microsoft - account for a whopping 14.70% of the S&P 500, which is the greatest over-concentration going back at least 43 years:
Now you might be thinking that the S&P 500 is doing a good job by adding to winners and riding them higher. This is a Trend-Following index, right?
While the S&P 500 does have Trend-Following characteristics (which is why I never recommend shorting it), at the end of the day it is still 100% long, 100% US equities and very top-heavy.
Due to this lack of diversification, I have previously predicted that SPY will experience a 5 - 10% gap down at some point in the future. However, that doesn’t mean I think such a gap down is imminent (I actually think SPY is looking increasingly constructive).
Also, this prediction isn’t exactly an extreme event that’s never happened before. When you over-concentrate into just a few big-tech stocks, there is a price to be paid, and you can see that the Nasdaq 100 has been scarred by numerous one-day plunges:
Interestingly, all of the top 10 declines have happened in my lifetime, so is it unreasonable to expect a few more of these in the years ahead?
The bottomline is that you cannot just simply look at the S&P 500 YTD return in isolation. Yes, it’s up, but how about the risk of a gap-down?
Is a 12.32% one day decline acceptable to you? It’s not to me. That’s why I trade small positions, go long & short, and diversify across different asset classes.
Trend Following Discussion:
I’m a big fan of Stockcharts.com and one interesting feature of that site that everybody can access for free is their Public Chart List.
This is an area where any member can publish and curate a list of their own charts and share them with the public.
One curious fact, however, is almost everyone on there is apparently obsessed with indicators. Pick any random list and chances are it’ll look something like this:
There are many more examples that are even more extreme than this, and they represent what Mark Douglas would call the “black hole of analysis”.
All successful traders must learn how to crawl out from this hole.
In any case, although the vast majority of publishers on this list have gone off-the-rails and are almost certainly unprofitable, there is actually one individual there that’s profoundly talented.