EDITOR NOTE: For the first time in history, we’re seeing central banks pull off what most economists might consider unnatural and unthinkable: making the stock market rise in an environment of zero to negative earnings growth. While earnings are supposed to validate and in some cases “ground” stock prices, central bank stimulus appears only to have vaulted stock market valuations, divorcing it further from the economy it's supposed to reflect. Wall Street and Main Street are now in two opposite worlds and the fundamental forces that have traditionally forced both to converge have been replaced by newly-issued money, prolonging Wall Street’s rise as Main Street crashes. The question now is how long this advance can continue and what the impending crash in valuations will look like once the paper stops flowing.
If you thought fundamentals, valuations and earnings growth matter the joke is on you.
In 2020 central banks have managed to do the unthinkable: Not only once again save investors from any damage in markets, but they intervened to such a degree that negative earnings growth is now the stuff of new record highs as well.
After all, never before have we seen indices vertically catapult to new record highs 2 years in a row on the cumulative reality of no earnings growth (2019) and negative earnings growth in 2020 with a multiple expansion of a near 50% in just 12 months with an unemployment rate of near 7% to boot.
As it’s all unprecedented it becomes a question of sustainability:
Central banks have proven it is feasible to create a historic disconnect between asset prices and the economy with the backdrop of declining earnings.
A key risk question is whether it’s sustainable even with an improvement in earnings. https://t.co/un6Z0ksL2X
— Sven Henrich (@NorthmanTrader) December 15, 2020
To get a visual appreciation of the vertical nature of the price action check a chart of small caps, up 17.5% on the year with negative earnings growth yet going vertical to new all time highs:
The chart apparently as vertical as the Citi Euphoria index:
If you are looking for precedence you will come up short as the vertical extension on some of these charts have no precedence.
Case in point, take a look at $RUT on a monthly basis:
The 10 MA oscillator has moved past the only to 2 previous all time extreme readings in the 15 range, now sitting above 21. Note the 2 previous occasions of extreme extensions above 15 resulted in an eventual reversal to and below the monthly 10MA.
Not only is the price action far extended, but price is entirely outside the monthly Bollinger band. As I outlined at the December 2018 bottom and again at the March 2020 bottom, markets don’t like technical imbalances, they lead to reversion and this market here is showing a historic imbalance as prices have been crashing to the upside.
And no, it’s not only small caps. Let me put this in a global context with the Dow Jones Global Index ($DJW) versus the monthly 20MA oscillator:
Not only is price entirely outside the monthly Bollinger band (which is unprecedented) but the monthly 20MA oscillator is at disconnect levels that has set up for reversions of size in the past.
While fundamentals, valuations and earnings growth haven’t mattered technicals are screaming for a coming reversion trade that will reconnect charts with basic moving averages. One of these will be the monthly 5 EMA. Here again the $RUT showing an over 13% disconnect from the monthly 5 EMA, a moving average that sees reconnects on a regular basis:
Something to keep in mind as markets are waiting for yet more stimulus into year end and the prospect of yet another Santa rally. Charts are stretched to the breaking point and reversion risk continues to build, hence from my perspective rallies remain selling opportunities for eventual technical reconnects. Ultimately these reconnects may offer long trade opportunities for new rallies or bounces, but for now these historic disconnects suggest the current trajectory to be unsustainable and a poor risk/reward proposition from the long side.
Originally posted on Northman Trader