Market internals refer to a set of indicators or metrics that provide insights into the overall health and performance of the stock market. These indicators can include measures like volume, breadth, and the number of advancing versus declining stocks. By analyzing
market internals, investors and analysts can assess market sentiment, gauge market trends, and make informed decisions about investing.
Full definition
We remain open to the possibility that investors will adopt a fresh willingness to speculate, but we need to observe further improvement
in market internals in order to draw that conclusion.
With our measures
of market internals deteriorating in recent weeks, even that factor is sputtering (see the November 13 interim update, Distinctions Matter — join our News List to have these special updates delivered to your inbox).
Even
if market internals improve, there should be no operating without a substantial safety net here (ideally using options, rather than one that relies on stop - loss execution).
Rather, it's essential to monitor the uniformity of
market internals across a wide range of individual securities (when investors are inclined to speculate, they tend to be indiscriminate about it).
Barring fresh breakdowns in
other market internals, an advance of just over 4 % in the S&P 500 on a weekly closing basis would be enough to shift our measures of trend uniformity to a positive condition.
We adapted our approach in mid-2014 to address that issue, which is why we're keenly focused
on market internals here (see the «Box» in The Next Big Short for the full narrative).
When
market internals improve alongside fundamentals, we would look to return to the target allocation for moderate growth / income of 65 % -70 % stock (e.g., large, small, foreign, domestic) and 30 % income (e.g., investment grade, high yield, short, long, etc.).
At present, we continue to identify one of the most hostile market environments we've observed in a century of historical data, not only because obscene valuations and extreme «overvalued, overbought, overbullish» syndromes are in place, but also because our measures of
market internals remain in a deteriorating condition.
One had to wait
until market internals deteriorated explicitly before adopting a hard - negative market outlook (which is the adaptation we imposed on our discipline in mid-2014).
Put simply,
with market internals unfavorable and interest rates off the zero bound, the two main supports that made the half - cycle since 2009 «different» have already been kicked away.
A modified version (that does not
use market internals such as $ ADV and $ DECL) trades Bonds, Euro Currency, Crude Oil, Gold, Soybeans, and the SPY ETF.
Those preferences can be largely inferred from the uniformity or divergence of
observable market internals across a wide range of securities and asset classes (when investors are inclined to speculate, they tend to be indiscriminate about it).
All of that tends to reverse itself once the cap - weighted averages break down, or
once market internals improve enough to suggest fresh risk - seeking among investors (though that sort of recovery is not typical at extreme valuations).
Market action is somewhat sensitive here, in that an improvement in
market internals over the near term could trigger some short covering, and possibly some amount of demand on improved confidence that the worst - case scenario for the economy has been avoided.
Still, the favorable
market internals did tell us that investors were still willing to speculate, however abruptly that willingness might end.
The central lesson was not that overvalued, overbought, overbullish extremes are irrelevant, but that in the face of zero - interest rates, one had to wait
for market internals to deteriorate explicitly before adopting a hard - negative outlook.
One has to tolerate a certain amount of cognitive dissonance to recognize that the S&P 500 is now 2.8 times the level at which it is likely to complete this market cycle, and yet allow for the possibility that investors could again take up the speculative bit (which we would infer
from market internals), and drive valuations to even further extremes.
First, recognize that in the context of
divergent market internals across a broad range of individual stocks, the kind of whipsaw stock market behavior we've seen in recent months has historically been more characteristic of market topping processes than not.
One of the elements of that process, as I observed approaching the 2000 and 2007 peaks, and again during the extended range - bound period of recent quarters, is that deterioration in
broad market internals — particularly following an extended period of overvalued, overbought, overbullish conditions — is a sign of increasing risk - aversion that typically precedes more extensive losses in the capitalization - weighted averages.
If
stock market internals were favorable here, we would quickly dismiss the prospect of an oncoming recession, for the same reason we would defer our concerns about potentially vertical market losses (see A Most Important Distinction).
Also, the same goes for US small caps which continue to lead the way lower, confirming the
negative market internals on Wall Street.
Yet even since 2009, the market has lost net ground following points
where market internals have actually deteriorated.
Regardless of other market conditions, our adapted discipline requires explicit deterioration in
market internals before adopting a negative market outlook.
Even more troubling is the reality that
weak market internals coupled with tighter monetary policy as well as extraordinary overvaluation do not bode well for future price direction.
Still, given the deterioration we observe in
market internals here, Wall Street's habit of dismissing and second - guessing every historically reliable valuation measure is likely to be rewarded by steep losses, as it has following every speculative extreme in history.
Presently, deteriorating stock
market internals suggest fresh skittishness among investors, which coupled with still - rich valuations (on the basis of normalized earnings) often results in particularly negative outcomes for stocks.
The combination of extreme valuations on historically reliable measures, the deterioration of
market internals following an extended period of overvalued, overbought, overbullish conditions, and the weakening of leading economic measures, particularly on measures of new orders and order backlogs, has clear precedents historically, and those precedents are uniformly bad.
When
market internals begin to break down, it's a signal that investor preferences have shifted toward risk - aversion.
The result is that an undervalued market can continue to collapse until
market internals demonstrate early improvement and positive divergences.
But in a risk - averse market without
robust market internals, central banks can throw everything at the wall, and very little will stick beyond a brief period of initial enthusiasm.
If the current advance is durable, we would expect to observe
stronger market internals, greater participation among higher quality sectors, and a clear easing of credit spreads, which remain near their highs despite the advance in equities.
Since
market internals only apply to stock index futures, we have additional methods to determine the trend of the Crude Oil market.
We could have avoided a lot of difficulty without that issue, but even without
considering market internals, history teaches that the longer value - conscious investors are wrong, the more seriously their views should be taken (remember Roger Babson).
As of last week, the Market Climate for stocks was characterized by unfavorable valuations (we estimate a 10 - year S&P 500 return of about 4.8 % annually), overbought conditions, and
mixed market internals.
The combination of wicked overvaluation coupled with deterioration in
market internals places current conditions among the most negative market return / risk profiles we identify (occurring about 8 % of the time across history, frequently with vertical losses emerging in those periods).
I expect that we'll maintain some amount of put coverage at least until we observe confirming evidence from high trading volume and improvement of more
conventional market internals.
Such an advance would give us trend uniformity essentially by default, by overriding rather than eliminating the negative
market internals currently present.