Tread Lightly!

I generally leave it up to my partner Tim to ascertain overall market direction, but I'm going to "Break Bad" and infringe on his space to make a strategic observation about the market as a whole. Tim usually makes shorter term observations, but this is a longer term one. I'll sum up the thesis with perhaps the most memorable line from the hit series "Breaking Bad", and say what Walter White said best "Tread Lightly". That is how I feel about the market. By now, most readers in the investor-oriented blog space have seen all the "lines" : bloggers whose drawings show the overall lack of breadth in the market, the disparity among market sectors, the decline in the number of new 52 week highs despite the market itself making new highs, a six year bull market historically being "long in the tooth", the relative performance of "Safe" vs. "Risky" markets, the surge in the dollar... and in treasuries ... and the collapse in commodity prices. Certainly, all of that is concerning. My attempt here is to do a little more "digging" and add yet another data point supporting the conclusion that everyone (silently or boastfully) believes, that is... all is not well with Mr. Market.

Here, an observation is made with respect to both fundamentals and market psychology simultaneously. It is, in a nutshell, the market's "voice". Consider the following thought experiment. If one were to become more and more concerned with holding stocks but were, nevertheless, forced to hold them (i.e. all of your long-only mutual fund managers), what would one do? One would play defense, of course. One would seek only the highest quality investments: those with reliable cash flow, dividend growth, low volatility, low leverage, and conservative accounting practices. Right? So what happens to the opposite investments, say, the unreliable cash flow and dividend growth, high volatility, high leverage, and aggressive accounting companies in this environment? They begin to lag.

What we show below is the compounded growth of two markets: The blue line is the market itself, as defined by the Russell 3000, the green line shows the performance of those companies in the bottom quartile based on their quality of earnings. We define a company's lack of earnings quality as one that has higher working capital accruals scaled by its average total assets over the last year, relative to its industry. So we have, in fact, captured a fundamental data point (earnings quality), and related it to a psychological data point (the actual buying and selling of high or low quality shares). What we see below is concerning. The market continues to make new highs, while low quality companies fail to keep up. They are failing to keep up at an accelerating rate. The last two times we saw this was between January and March of '00, and August and October of '07, the last two major market tops. Only now, this phenomenon has been occurring for a longer period of time. That might be a reason to become even more worried.

Russell 3000 (Blue Line) Vs. Low Earnings Quality Companies (Green Line)