Kass: This Market Looks as Serene as a Duck, but There's Turmoil Underneath

"When I see a bird that walks like a duck and swims like a duck and quacks like a duck, I call that bird a duck."

-- James Whitcomb Riley, Indiana poet (1849-1916)

"I can't prove you are a Communist. But when I see a bird that quacks like a duck, walks like a duck, has feathers and webbed feet and associates with ducks -- I'm certainly going to assume that he is a duck."

-- Emil Mazey, secretary-treasurer of the United Auto Workers (1946)

"Suppose you see a bird walking around in a farm yard. This bird has no label that says 'duck.' But the bird certainly looks like a duck. Also, he goes to the pond and you notice that he swims like a duck. Then he opens his beak and quacks like a duck. Well, by this time you have probably reached the conclusion that the bird is a duck, whether he's wearing a label or not."

-- Richard Cunningham Patterson Jr., U.S. ambassador to Guatemala (1950)

NEW YORK (Real Money) -- The historical derivation of the "Duck Test" is uncertain. Above are three popular and possible origins.

The test is a humorous term for a form of inductive reasoning. Its usual expression is: "If it looks like a duck, swims like a duck and quacks like a duck, then it's probably a duck."

The Duck Test implies that a person can identify an unknown subject by observing that subject's habitual characteristics. It's sometimes used to validate the argument that something isn't what it appears to be -- like today's market.

In my decades in the investment business, I've never seen a market with no inclination to decline in the face of numerous potential adverse outcomes and strong secular headwinds. (I recently highlighted 13 big-picture factors that could weigh on markets and the economy and markets in "Short in May and Go Away.")

As Jim "El Capitan" Cramer wrote in "Gulf Widens Between Haves and Have Nots": "The dichotomy between what is working and what isn't working has grown gigantically." The rotation within groups and sectors is fast and furious -- maybe the most vicious I've seen in my investment career.

Today the market is like the anecdote about a duck. It looks serene gliding across the pond, but underneath the surface it's furiously paddling. The market is like that: you look at the price chart of the S&P 500 (SPY) and it just keeps gliding higher, while underneath the surface there's massive turmoil.

Consider:

  • New 52-week highs have been declining on every rally since February;
  • S&P 500 stocks over their 200-day averages have shown lower highs on every rally since last September;
  • Health care and technology are the only major sectors even close to maintaining breadth and momentum;
  • Utilities peaked in January's last week and are now nearly 10% below that top;
  • Energy stocks topped out in April 2014 and today are about 21% below that peak;
  • Transports made their highs in November and last week broke major support levels, standing 17% below their highs.

This paddling of the market's feet under the water's surface is typically a sign of a maturing market, but there's nothing typical about today's market. A market without memory from day to day -- in which big up days are routinely followed by big down days (and visa versa) -- isn't normal, although it's become the norm.

At the same time, volatility measures have been extraordinarily low, but the volatility of individual securities has been very high. Nor have index/group/sector breakouts had any followthroughs, although breakdowns have also been kept to a minimum.

How do we explain the serene market above the water's surface and a volatile market just below?

Perhaps the major individual and sector/share price volatility is a function of pronounced takeover activity that's now at record levels. Or perhaps it's the importance of financial engineering (share-buyback activity) that explains all of this.

Or maybe the market's inconsistencies and developing changes are a function of the markedly increased role of high-frequency trading, price-momentum strategies and the dominance of ETF trading.

The key question today is whether one believes that this "duck paddling" -- narrowing market participation and erosion in a number of leading sectors and stocks -- is a precursor of a larger correction, or whether the recent weakness is a healthy consolidation in preparation for another leg higher.

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