You Ever Think Maybe the Markets are Crazy, and I’m Not?

Three weeks ago I shared some thoughts about valuations and market internals: How to Survive This Bull Market. The bottom line: History suggests we are very close to a major decline in the U.S. stock market.

Keyword: close.

Indeed, everyone and their Japanese housewives have been looking for reasons to get out of Dodge.

Apparently they’ve found a bunch of reasons …

Yep, U.S. equity fund and ETF outflows have totaled more than $78 billion in 2015.

Yep, that’s more than any other year since 1993, including 2008 and 2009.

Yep, money is instead flowing steadily into international funds, particularly those in Europe.

The biggest explanation for this year’s dramatic fund flows is the anticipated divergence of global central bank policy.

While the U.S. Federal Reserve is widely expected to begin hiking their benchmark Fed Funds rate next month, the European Central Bank and the Bank of Japan are staying accommodative or becoming even more so.

And this all tells me, it looks like a decent time to buy U.S. stocks — the last hurrah is coming.

Am I crazy?

***

Howard Gold, at MarketWatch, looked a little closer at the fund flow data I just mentioned. And he agrees that this is a contrary indicator suggesting an opportunity to buy stocks.

From 1993 to 2004, fund and ETF investors overwhelmingly favored U.S. stocks, and inflows to U.S. equity funds topped international investments every single year.

But it reversed dramatically starting in 2005 …

During the past 10.5 years, U.S. investors shoveled almost $1.2 trillion into international equities, while withdrawing a net $9.8 billion from U.S. equity funds and ETFs.

From January 2005 through Aug. 17, the MSCI EAFE Index of non-U.S. developed market stocks gained 1.6% a year.

Meanwhile, the Wilshire 5000 Total Market Index gained 7.4% a year, the S&P 500 Index rose 7.7% a year and the Russell 1000 Index advanced 8.1% on an annualized basis over those 10.5 years.

Investors get out of the U.S., and then the U.S. market outperforms.

Investors get into the U.S., and then international markets outperform.

Now who’s crazy?

***

You want more evidence that I’m not just some kind of kamikaze trader in contrarian clothing?

Frankly, I think we need more buyers before we can have a surge of sellers that crashes the equities bull market.

Fund flows certainly don’t indicate irrational exuberance. The fact that hedge funds’ bearish bets exceed their bullish bets doesn’t indicate overly optimistic money managers.

Neither does market breadth.

Market breadth measures participation in the stock market. There are a couple ways to determine breadth:

•  NYSE Advance/Decline Line: The number of stocks advancing vs. those declining

•  NYSE High/Low Index: The number of stocks making new highs vs. those making new lows

•  S&P 500 Bullish Percent Index: The number of stocks with bullish vs. bearish point & figure signals

I would expect to see bullish exuberance, a high proportion of new highs vs. new lows and far more stocks advancing than declining.

To me, that would indicate a top because it would create an opportunity for big buyers to liquidate positions and leave the Johnny-come-latelys holding the bag. When small investors become so extremely excited to accumulate stocks, owners of large positions can distribute their holdings to those willing buyers.

I just don’t see that composition in the markets right now.

Barring some risk-aversion catalyst, the recent range and resilience in the broader U.S. stock averages suggest an eventual breakout to the upside.

***

I understand if you think I’m crazy now — I’m essentially suggesting you buy U.S. stocks in the face of last week’s selling and a litany of bearish data points.

So let me throw you a bone. (And hedge my bets a little bit!)

Consider again U.S. industry price-to-cash-flow valuations:

Image credit: Gavekal Capital

At the bottom: Energy & Utilities. Among the top: Pharma, Consumer Durables & Apparel as well as Retailing.

It might be a little early to start betting on energy.

Utilities, though, are equally undervalued relative to the rest of the pack.

Utilities pay a nice dividend, too, which eases the pressure of holding the shares should utilities need more time to find their footing.

On the other side of the equation, consider retail and consumer durables & apparel.

One commentator I read last week noted significant headwinds for retail. To paraphrase:

The retail space has doubled since 1990 even though American buying power certainly has not.

Mall vacancies have been roughly 9% per year since 2007, nearly double the rate that year. Sales are rising on average at 0.5%, one-quarter the rate they were growing up to 2007.

Household debt remains below credit crunch levels, revealing consumer appetites remain tempered.

All the while, corporate maneuvering, including share buybacks, is likely to reveal a significant debt-burdened for major retailers.

Plus, on a price-to-cash flow valuation basis, retail is frothy.

The price-to-cash flow for Consumer Durables & Apparel is triple what it was in 2008. For Retail it is double.

If you wanted to pair a long position in utilities with a short position in retail, it wouldn’t be too crazy.

Since I first proposed that idea a few weeks ago, the Utilities Select Sector SPDR ETF (XLU) has risen 4.15% while the SPDR S&P Retail ETF (XRT) has fallen 3.11%.

Not a bad call.

Have a crazy week.

Do right,

JR Crooks

“JR” specializes in trading commodities, currencies and options. He has spent nearly 10 years analyzing financial markets and writing about global economics. JR honed his trading techniques and global-macro worldview alongside his father, Jack Crooks, at Black Swan Capital. JR also…