Today I want to discuss the role of intermarket analysis in assessing the risk appetite of market participants. I’ll outline the charts I’m looking at across all asset classes and give my thoughts on them. I think US markets are structurally the best in town, but some of the technical damage we’ve seen develop year to date will take some time to repair itself.
The first chart I want to look at is the S&P 500 versus the Emerging Markets ETF. This chart really highlights that even as I have been expressing concerns about US equities over the past few months and think that we’re due for continued volatility over the intermediate term, US equities are still the best game in town from a structural perspective. We have put in a long term rounding bottom against emerging market equities and as long as we stay above the gray shaded box, there is no reason that US equity market outperformance can’t continue.
The chart below is that of the YTD performance of microcaps (IWC), small caps (IWM), mid caps (MDY), the S&P 500 (SPY), the Dow (DIA), and large cap tech (QQQ). As you can see here, we’ve seen performance get progressively worse as you move up the equity risk spectrum with small and microcaps leading to the downside and large cap, market weighted indices leading to the upside. Normally in a risk-on environment you’d want to see the opposite occuring.
As you can see from the chart below, the S&P 500, the large cap market weighted index is breaking out relative to the Russell 2000, a small cap index. Based on the chart below, we can see that this outperformance of larger cap names has been occuring all year and will likely continue until we reach long term resistance up near 1.95-2.00 on this particular ratio.
Below is the same ratio, except with IWM as the numerator. As you can see, IWM/SPY is back at levels not seen since ’09, which signals that this will likely continue to be a headwind for the broader markets.
Additionally, from the ratio chart of microcaps relative to the S&P 500 (IWC/SPY), we can see the false breakout that occured earlier in the year and the subsequent crash toward lows not seen since ’11 and ’09. Again, microcap underperformance is not indicative of a risk-on type of environment.
This chart is looking at the YTD performance of the 9 S&P 500 sectors, as measured by the select spdr etf series. As you can see below, utilities, healthcare, large cap tech and consumer staples are leading. This is indicative of a defensive shift in asset allocation toward the lower risk, larger cap sectors of the market.
Speaking of a defensive shift in terms of sector performance, the next two charts show that consumer staples (XLP) are breaking out relative both the S&P 500 and the consumer discretionary sector (XLY).
Another sector that you’d like to be seeing outperform on an absolute and relative basis when there is real risk appetite in the market is regional banks. The ratio chart below of regional banks versus the financials sector (KRE/XLF) shows that this ratio put in a double top and has been rolling over for a good portion of 2014. It’s bad enough that financials are underperforming the S&P 500 on a relative basis, but now regional banks, which are almost like “small cap financials”, are underperforming the larger cap banks as well.
As you can see by the chart below, regional banks are acting poorly on an absolute basis as well. The 50/200 day SMAs are rolling over an momentum continues to fail to reach overbought territory. Price continues to test this 36.60 area and the more times the level is tested, the more likely it is going to break. If this starts to break down like small and microcap stocks have already, this will be just another headwind for the broader markets as a whole.
As you can see from the charts below, micro caps and small caps have similar patterns to that of the regional banks, but have already broken down and are leading to the downside.
If things weren’t gloomy enough, a lot of the momentum sectors of the market saw some pretty bad breakdowns over the past few weeks. The first is the solar sector. This weekly chart shows that TAN has been bumping up against long term resistance with a pretty large momentum divergence and is finally breaking to the downside. With a downward sloping 200 week simple moving average, things could get ugly here.
Another sector that has led to the upside has been the semiconductor index. As you can see below, we’ve broken a two year uptrend line on a gap down after putting in a nasty negative divergence in momentum over the past few months. Again, it will be tough for the market to continue higher with its leaders looking like this.
This post is getting pretty long, but another important factor that I’m looking at is the breadth of the market. I think these next two charts sum things up pretty well, so I won’t belabor the issue long, though it is an important one.
This first chart is the equal weighted S&P 500 index etf versus the market cap weighted S&P 500 index etf (RSP/SPY). As you can see the ratio has been rolling over, showing that less and less stocks are participating in the rally as the large cap S&P 500 index grinds higher. This is obviously unsustainable, which is why we are seeing weakness the past few weeks as the large cap leaders rest or pullback themselves.
The next chart is the percentage of NYSE stocks above their respective 200 day simple moving averages. As you can see, as the market made new highs, less and less stocks were participating and as we sold off this percentage tanked to levels not seen since late ’11, early ’12. Again, this adds to the case that we are seeing a push into larger cap, more defensive equities. What we’re seeing here in the NYSE as a whole can be said for a lot of the indices whether it be the S&P 500, Nasdaq, or any of the sectors.
Fixed Income Markets:
The first chart we have below is the YTD performance of long term treasuries (TLT), municipal bonds (MUB), treasury inflation protected securities (TIP), and junk bonds (JNK). As you can see, long term treasuries have outperformed all of these types of credit by a WIDE margin and junk bonds are actually the laggard, returning roughly ~1.5% YTD. Clearly if there was any risk appetite, we’d be seeing junk bonds lead and not long term treasuries.
I know you’re probably thinking, what about emerging market bonds? Well by creating a ratio chart of long term treasuries versus emerging market bonds (TLT/EMB), you can see a clear rounding bottom developing over the past two years and now a breakout to the upside. Again, if there was risk appetite out there, emerging market bonds should be outperforming long term treasuries, at least in my opinion.
In the ratio chart below, we can see that long term treasuries (TLT) are breaking out relative to junk bonds (JNK) on a long term basis. We are currently breaking out above a 5 year downtrend line and moving higher, with a lot of room to run.
The first curreny pair, one that typically leads in a risk-on environment, is EUR/JPY. After a huge run higher the past few years we were consolidating but are now threatening to break this one year support level. Momentum remains in a bearish range as we look to breakdown below this 135.50 level and head lower after a false breakout a few weeks ago.
We’re seeing something similar in AUD/JPY. This is another one of those currencies you want to see leading in a risk-on type environment. What we’re seeing now is the currency pair breaking down in both price and momentum terms. We closed on the lows of the week and are looking to break longer term support to the downside.
The next pair is AUD/USD. This is a weekly chart and as you can see after failing to hold above .92 earlier in the year, we are now testing the lows near .86. Momentum has broken down and is now hitting oversold levels as well. We closed last week near the lows and look to be setting up for a move lower toward .80.
The last currency is just simply the dollar index. I don’t know when the last time I heard someone say “the dollar is ripping, must be risk-on”. Maybe I’m naive with that assumption, but just from my own experience and observations, this is not typically behavior that is indicative of increasing risk appetite on the part of market participants.
As you can see from analyzing a variety of markets, we are not seeing a lot of risk appetite out there. Obviously I threw a lot of information out there (and left some out for time’s sake), but I think it’s important to be aware of these types of developments as you navigate the market. We’ve seen these divergences for a while and trying to time the straw that breaks the camels’ back and sends the indices lower is a fools game. What it can be useful for is to allow you to take a more cautious stance in the market until we see these issues resolve, or in this case, come to fruition in the form of a correction. Clearly there has been a defensive shift in asset allocation and a diminishing risk appetite for quite some time and now we are finally seeing the effects of that. I think we continue to see some volatility over the intermediate term as we attempt to repair the technical damage done within the context of a longer term structural uptrend in the US equity indices. I hope this was interesting and if you have any questions, comments or concerns, feel free to contact me (info on about page).