ANATOMY OF A MARKET TOP

“If it keeps on rainin’, levee’s goin’ to break.” – Led Zeppelin 

Crashes get all the headlines, but the reality is that a breakdown in markets is more often a process than an event. It takes time to break the back of a strong uptrends as there are many buyers on the sidelines eager to “buy the dip.” This is why you tend to see a period of back and forth, a rotation from strong hands to weak hands, before the sharper declines ensue.

If we look at the average stock in 2014 as reflected by the Russell 2000 Index, this is precisely what we have been witnessing for the entire year.

Where have we seen this before?

2000…

2007…

The First 7 months of 2011…

But It’s Different This Time

The perception today is that it’s different this time. This belief stems from the view that the Fed has repealed the business cycle and eradicated market corrections through nearly six year of 0% interest rates and multiple rounds of quantitative easing. The validation for this narrative comes in the form of price action and the longest uptrend in the history of markets. At 471 trading days above the 200-day moving average in the S&P 500, most cannot remember a time when equities did anything but go up.

Perhaps the Fed true believers are right, you say, and the uptrend will last forever. Anything is possible in markets but the more likely scenario is that it’s finally coming to an end here.  The sustained weakness in small caps, high yield credit, and cyclical sectors is becoming too much for large caps to ignore (see here for comparison to 2007).

Small caps, mid-caps, Emerging Markets, and European equity markets have all tested their 200-day in recent days/weeks. All that remains is large caps; it is the last shoe to drop. I have been arguing for much of the year that investors have been rotating into U.S. large caps and defensive areas, hiding in anticipation of the end of QE in October (see “Fed Prisoner’s Dilemma”).

Well, October is here and investors may soon come to understand that U.S. large caps are not a risk-free asset class, in spite of what Fed has done over the past six years.

The chart below of the Russell 2000 is likely to become very important in the coming months. It illustrates the back and forth action that is reminiscent of 2007.

I’ve heard a number of perma bulls call this a “beautiful consolidation,” just a pause before the next sharp move upward. Perhaps, but if they are wrong and the levee of support (YTD lows in February and May) is broken, there could be significant downside ahead.

Will it break or will it hold? On this question I’ll defer to the wisdom of Page and Plant: “If it keeps on rainin’ [negative intermarket relationships persist], levee’s goin’ to break.”