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Two conditions keeping investors on edge

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In case you haven’t noticed, the S&P 500 has been in record territory for about a year.

Since April 2013, it has broken successively higher records despite loud disagreements among analysts and strategists about whether these levels are justified or not. Just this week it reached another record, crossing the psychological 1900 level for a brief moment.

After losing about half of its value five years ago, the S&P 500 is now almost three times higher than its worst level of March 2009. Yet, despite this stunning rally, it is hard to find investors who are exuberant about stocks today like they were about internet stocks during the dot-com frenzy, houses in the real-estate boom, or gold when everything else seemed toxic.

This is not typical: when assets boom, people tend to jump in. But those who remember the 1999 book “Dow 36,000” will be hard-pressed to find any book remotely as optimistic in the bestseller lists today.

So the rally grinds on, with or without the public’s conviction. The indifference with which investors are greeting these record levels is, paradoxically, bullish. Markets reach a peak when everyone is all-in and there is nobody left to buy. Since there is still plenty of spare capacity to load up on stocks, the potential for further strength is undeniable.

But market reversals are not just caused by too much exposure. Things can take a turn for the worse if people get scared by unexpected events, or if confidence weakens when conditions deteriorate. The problem is that by the time the scary stuff hits or weaker conditions become evident, it is usually too late. That’s why investors who are already skeptical scrutinize the market for clues of hidden dangers.

Some of those signals have appeared in recent weeks in the form of sharp divergences between aggressive and defensive stocks.

Large cap stocks and small cap stocks, for example, have gone in opposite directions. To pessimists, this is a clear warning that the market is heading for trouble.

Small Cap / Large Cap divergence

Indeed, there is little evidence – actually, none – in the last 14 years that a market rally like this one can actually take place without aggressive stocks being at the forefront of performance.

A chart showing the S&P 500 and the difference between the total-return Russell 2000 index of small cap stocks and the total-return S&P 500 (rebased to May 2000) shows how sharply small caps have underperformed large caps. Apart from a few days here and there in the last 14 years where both measures don’t march in lockstep, this situation is truly unique.

This is worrisome because, generally speaking, small caps need favorable economic and financial conditions to prosper. Their severe underperformance suggests that the market is convinced that those conditions are about to worsen.

Small Cap / Large Cap divergence

Similarly, there are very few instances when the general market breaks new records while consumer discretionary stocks underperform consumer staples. Consumer discretionary stocks are those of companies that people can live without (like Tiffany’s). They tend to do well when everyone is ebullient about the economy’s outlook. But discretionary items don’t sell as well as staples that people still need to buy during economic downturns (like food and soap). Again, the discrepancy between a record-breaking market and the weakness of an aggressive equity sector like consumer discretionary is stark.

Other indicators paint a more benign picture.

Volatility, for example, has remained remarkably low: there was only one day in the last month when the S&P 500 moved more than 1% in either direction. Inter-asset correlation, while still somewhat elevated, has so far remained stable. And interest rates, which had been expected to soar, have not moved much in months – the 10-year US Treasury note has remained pretty much constrained to a narrow 2.60%-2.80% range since January.

Optimists will shrug off the divergence between aggressive and defensive stocks as insignificant, while pessimists will look at conditions that suggest calm and see them as a prelude to the proverbial storm.  It is impossible to say who’s right, but it is clear that the unusual conditions we described will keep investors on edge and uncommitted, even if the market continues to crawl to higher levels.

What now?

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