Sometimes the bomb might explode without any warning

In the fallout from the Putin-Trump summit, we heard plenty of comparisons to the Kennedy-Khrushchev summit in 1961 which the then US president described as the "worst thing in my life." While we would be surprised if Mr. Trump felt the same way about the Helsinki summit, the comparisons with 1961 did get us reminiscing about the cold war, perhaps prodded by finding ourselves in the throes of a global trade war.

Just as everyday life went on as usual during the cold war, so does market life during America's trade war with the rest of the world. Yes, the S&P 500 is off its all time high, but consensus now seems to be that it is only a matter of time before it marches past the historic high water mark of 2,872.87. After all, the Nasdaq Index is making new highs almost daily. So, no need to worry that the costs of tariffs are starting to hit America's shores even as the Federal reserve is tightening financial conditions. Conventional wisdom has it that we are way off from either of those factors having a material impact on the US economy and market.

Such thinking may well be right. Unfortunately, it is very hard to predict when those factors might collide to produce a chain reaction of risk aversion and selling. As they used to say back in the cold war, sometimes the bomb might explode without any warning.

If the market is hit with sudden risk aversion, it will not take much to break the rally. Over the past month, the leadership in the S&P 500 (up 1.1%) has been dominated by only three of the original FANG stocks:

1. Amazon (Mostly Sunny; AMZN) +7.5%2. Facebook (Mostly Sunny; FB) +7.2%3. Alphabet (Mixed; GOOGL) +4.6%.

The common denominator among the three leaders is essentially the monopoly power that each have in their respective markets. Notably, following our warning on June 13th, Netflix (Cloudy; NFLX) appears to have lost its monopolistic edge as it acknowledged emerging competition from YouTube, Disney (Cloudy; DIS), and Amazon in its Q2 earnings report. With Netflix's star falling, that really leaves us with a GAF market driven by the three names listed above. Meanwhile, small caps once seen as evidence of a broadening market rally are losing steam. Smaller names, as tracked by the iShares Russell 2000 Index ETF (IWM), have lagged over the past month, down 0.2%.

The fact that two out of the three GAF stocks continue to have mostly sunny outlooks is positive for the bulls as it suggests that they may still have the ability to pull the market higher. However, if the clouds were to move in on just one of the two remaining names, it could spell darker times ahead for the market. As we wrote last week, insiders who make their living on Wall Street have headed for cover. Wall Street titans are more interested in taking money out of the market this summer than in putting it to work. Meanwhile, broad insider sentiment is weakening with our INK US Indicator now below 30% meaning there are fewer than three stocks with insider buying for every ten stocks with selling.

Finally, we continue to see growth stocks outperforming value. The iShares Russell 1000 Growth Index ETF (IWF) is up 1.3% over the past month, ahead of value stocks as measured by the iShares Russell 1000 Value Index ETF (IWD) which is flat. This widens the 1-month outperformance of growth over value to 1.3%, up from 1.0% last week. For the bull market to pick up some broad steam, we believe that value stocks will need to assume leadership as it would signal that growth is plentiful in the economy. At that point, investors would no longer have to pay a premium for growth, and instead could look for value in the market.

We believe the switch from growth leadership to value is important because we do not believe it is sustainable for expensive growth stocks to lead the market during a period of tightening financial conditions. Eventually, there just will not be enough extra cash in the economy to chase a GAF stock trading at a premium multiple. As the central bank created liquidity showering GAF stocks dries up, the bomb may soon go off.

INK Edge outlook ranking categories (Sunny, Mostly Sunny, Mixed, Cloudy, Rainy) are designed to identify groups of stocks that have the potential to out- or under-perform the market. However, any individual stock could surprise on the up or downside. As such, outlook categories are not meant to be stock-specific recommendations. For background on our INK Edge outlook, please visit our FAQ #5 at INKResearch.com.

The original version of this article appeared in the US Market INK Report, July 18, 2018