Consolidation Continues As Investors Take Profits and Rotate Into Value

The Dow Jones Industrial Average closed at a new 52-week high yesterday — with little fanfare. While the Dow Jones Transports and the S&P 500 are close behind, the Nasdaq Composite and the Russell 2000 are still well below their previous 52-week highs. As we have discussed on the weekly podcast over the past month, this was a result of profit-taking in momentum stocks found in the Nasdaq and Russell 2000. That money didn’t go to cash, however, and mostly rotated into value plays, large-cap stocks, energy, utilities, and staples. This is a function of profit-taking, de-risking portfolios, and geopolitical themes (Chinese stimulus and Russian energy threats). For the overall stock market to resume its bullish trend, the Nasdaq and the Russell will need to join the party again. If not, we could be looking at a significant correction in this secular bull market.

This isn’t the first time we’ve seen a quality rotation. I remember the same quality rotation back in 2000 when investors liquidated tech stocks to own large-cap, mature companies in the S&P 500 and the Dow Jones Industrial Average. When the Nasdaq fell 30% from early March to the end of May 2000, the S&P 500 and the Dow had gained 2% and 3.5% respectively. I’m sure there was profit-taking there at the time as well, but the divergence between these three widened because some of that money was rotating.

The defensive rotation these last two months has been well documented by the media and by analysts. While the market can stay elevated if investors allocate out of one area and move to the next within the same market, it’s not ok if those investors are moving to cash – and that’s not happening.

The Investment Company Institute (ICI) tracks money flow into and out of mutual funds and their recent Trend in Mutual Fund Investing data for March shows that investors were increasing their exposure to stocks and bonds, and out of cash. Finally, it has hit home that cash is trash and at 0% interest rates and a stock market that was up 30% last year, the feeling of “We have to do something with this cash” has hit home. With average valuations for the stock market, it’s not surprising that this cash is going into both bonds and stocks, especially since long-term rates have been tame over the last few months.

Source: ici.org

So investors are not deleveraging—which can result in significant market corrections—they’re de-risking and rotating. That’s the case now, but as I have said, we need the whole market functioning with investments broad in scope and all market caps working. The Wilshire 5000 contains 5,000 cap-weighted U.S. securities and is much broader in scope compared to all four of the indices I mentioned above and the trend is still higher highs and higher lows. The consolidation has been constructive, working off the February rally with a higher low in April.

So while I get that technicians are concerned that momentum stocks are not participating in the economic-and-Fed-speak-rally in April, there’s still plenty of signs that investors are engaged in this market with fund flow data showing outflows from cash. This is simply a thematic play here in defensive areas of the market as investors rotate, which we commonly see take place during consolidations. With that said, it is unclear if this is a two-month theme or longer at this time. If the stock market can’t reach new highs, if the Nasdaq and Russell 2000 continue to lag, and if momentum and small-cap can’t find a bottom, we could be looking at a necessary correction in the rest of the market to attract buying.

I don’t think that will be the scenario that plays out with economic indicators rising in March and April; however, positive economic surprises haven’t been enough to break the ceiling here. Will that be the jobs data tomorrow? A recent poll I saw on CNBC suggested that investors are putting a lot of emphasis on the jobs data to make decisions on the market and the economy. We’ve seen major moves in the market on jobs report announcements over the past couple of years, so the poll does have merit.

In summary, as investors, we all need to be cognizant of the rotation and not ignorant. We also need to understand if the overall health of the stock market is still in good shape, as referenced by the Whilshire 5000, in addition to mutual fund flow data that tells us investors are still engaged in stocks and bonds. Our forward trajectory will likely depend on continued economic surprises as well as technical signals from the Nasdaq and the Russell 2000. Below are just a few charts on the major indexes for reference. Note that the Dow Industrials and Transports would confirm a new buy signal if the Industrials can breakout above 16,600.