Stocks and Bonds - One of These Markets is Wrong
If one looks only at the SPX and the DJIA, one would have to conclude that stock market participants firmly believe in the recovery story that is peddled far and wide. After all, these indexes have only just retreated from new all time highs. However, something doesn't compute in terms of the 'market message'. Small caps and momentum stocks (mainly tech stocks in the widest sense) continue to leak, and they have been the leaders of the bull market.
That is not the only problem though. 10 year treasury note yields have just dropped below the short term support level we recently flagged as 'vulnerable', and they have done so with gusto, by gapping right through it. Here is an updated chart:
10 year yields break support – if there is one thing that could be construed as slightly encouraging for bond bears, it is the fact that 30 year bond yields are slightly diverging, but that may be simply because they have been leading the march lower thus far – click to enlarge.
We reiterate that there is only one sensible conclusion from this market behavior: similar to when 'QE1' and 'QE2' ended, the bond market is signaling that the removal of extra liquidity by the Fed is going to result in economic weakness in the not-too-distant future. After all, one can hardly argue that the Fed's buying is causing yields to drop when said buying is declining every month. It is noteworthy that yields are going lower even though the government's 'inflation' data, which purport to measure the mythical 'price level', have produced upside surprises of late.
Furthermore, the Russell 200 index has turned into the weakest major index. Small cap stocks are generally considered 'economically sensitive', mainly with respect to the domestic economy.
The Russell 2000 – closing in on support. The 50 dma has turned down, and the index has closed below the 200 dma for the fifth time this month (and this year) – click to enlarge.
What is interesting about this is also that the Russell has seen the by far biggest amount of futures speculation on the way up. At one point, the value of the net speculative position in large and mini futures combined was approaching $30 billion (about 50% of the stock index futures total). This is beginning to change, and a noteworthy divergence has been recorded between the net speculative position and prices at the peak.
Comparing yields with the SPX, we can see that a strong divergence has developed lately. There is of course nothing that says that yields and the SPX must be positively correlated all the time – it all depends on the contingent historical circumstances. However, they have been broadly positively correlated over short to medium term periods since 1998, a notable change from the behavior that pertained from about 1969 to 1998 (when a strong negative correlation was in evidence most of the time). It all depends on whether the market fears 'inflation' or 'deflation' (in the sense of price levels). At the moment, they should be positively correlated, which is one of the reasons why so many people were bearish on bonds at the beginning of the year and have stayed stubbornly bearish ever since. In 10-year note futures specifically, speculators have still held on to historically very large net short positions as of the most recent reporting period.
The 10 year yield and the SPX: diverging since the beginning of the year – click to enlarge.
Again, we suspect that only one of these markets is likely to be 'right', but not both.
Bull Entrapment
The Russel 2000 index has of course begun to correlate much more closely with bond yields recently, so it appears that at least this sub-sector of the stock market 'agrees' with the bond market's message.
10-year yield and the RUT - click to enlarge.
This also means that the Russell and the NDX continue to plummet relative to the SPX – with both ratios reaching new lows on Wednesday. It is actually quite rare for such a divergence to become this large. While one or the other index may diverge and lead out of turning points in the short term, they usually become very quickly directionally aligned. At the moment it is as though one were looking at completely different markets. We would suggest that one reason for the extent of the divergence is that there is still enough liquidity being pumped into the system to hold up a part of the market, but no longer enough to hold up all of it.
The ratio of RUT and NDX to SPX: falling to new lows – click to enlarge.
If falling bond yields and the weakness in the Russell indeed indicate that US domestic economic activity is in danger of weakening, then the indexes that are still holding up at present will eventually follow suit and weaken as well. Note that we are differentiating between 'economic activity' and 'genuine economic growth'. The two are sadly not the same thing in an inflationary fiat money system hooked on incessant massive debt growth. This is also why the stock market cannot be considered an indicator of the economy's health. It is merely an indicator of the degree of monetary pumping (if that were not so, Venezuela's economy would have to be regarded as the most healthy in the world).
However, the divergence between SPX and Russell/NDX has also produced another noteworthy effect: it seems to be setting a trap for overly confident market participants. We can see this in certain positioning and sentiment data. Consider for instance the 'classical' Rydex ratio (Nova/[Nova+Ursa]):
Rydex traders aren't sensing any danger yet, which is no doubt a result of the SPX remaining close to an ATH - click to enlarge.
A similar picture emerges when looking at the total ratio of bull vs. bear assets in the Rydex fund family. One must keep in mind that although these funds are fairly small relative to the market's size, they do per experience represent a statistically significant sample of trader sentiment. In other words, they are a good way of measuring the degree of complacency or fear (one must be far more circumspect with interpreting positioning in stock index futures. They haven't been straightforward contrary indicators since at least the early 2000ds).
On the next chart one sees the disaggregated bull and bear assets as well, and it becomes clear that the main reason why the ratio has exploded into the blue yonder is that bears have been utterly intimidated and demoralized. This is usually the time when it pays to think about adopting a bearish stance. Even if one fails to time the next major move with precision, it may well pay off, especially as long as 'protection' remains extremely cheap. As an example for this consider the silver blow-off in April of 2011.
Anyone who bought SLV puts from prices of $35 upward was handsomely rewarded, in spite of the fact that the market rose by an additional $15. Volatility premiums on puts made such an explosive move when the market cracked that their expansion more than made up for lost time premium (note however that both the final rise and the subsequent fall happened in a very compressed time period in this case – the stock market usually moves at a far more leisurely pace, so one must adapt tactics accordingly).
Rydex bull and bear assets, and the total asset ratio. Bears haven't even been similarly discouraged when the Nasdaq experienced its late 99/early 2000 blow-off move – click to enlarge.
Of Junk and Curve Inversions
Lastly a chart that shows the relative performance of JNK vs. TLT. While TLT's performance accounts for the bulk of the move, it is basically a case of momentum in junk bonds having stalled out in parallel with the strong move in treasuries since the beginning of the year. As a result, credit spreads are moving higher, and rising credit spreads are a warning sign.
In this context, we also want to briefly comment on an argument we have come across several times lately, namely that 'there cannot be a recession or a bear market before the yield curve inverts' (see e.g. this very recent article at Marketwatch as an example). As the yield curve is currently still quite steep, and the Fed is committed not to raise the FF rate until sometime in 2015 at the earliest, a putative inversion is of course still very far away, and the economy and markets are therefore considered 'safe'.
See, this is easy, you only have to wait for the curve to invert, then you can sell. One wonders where these gurus were when the yield curve did invert in 2006. We know of a few observers who pointed out that the event presaged a downturn, but we cannot recall any warnings having found their way into the mainstream financial press at the time.
Anyway, the point we want to make is that it does not always work that way, i.e., it is not that easy. There are at least two conditions that can stop the signal from being given in time: an explosion in long term inflation expectation combined with a central bank that is 'behind the curve', and the situation we find ourselves in right now: when the central bank holds overnight rates at zero. Just ask yourself when Japan last saw a yield curve inversion. Let's just say that many of the real time witnesses of the event are no longer among the quick, having perished from old age.
That certainly hasn't kept Japanese stocks from entering several severe cyclical bear markets (which shaved between 50 to 70% off the Nikkei index) and it also hasn't kept its economy from experiencing frequent recessions. Under a ZIRP regime, the market can indeed plunge even though no yield curve inversion was in sight beforehand. It is probably a good thing to be aware of this.
JNK – TLT: this isn't exactly good either. Clearly the trend has turned in the 'wrong' direction since the beginning of the year – click to enlarge.
Conclusion:
The recent ATH in SPX and DJIA has produced the 6th negative divergence between different indexes since the last trading day of 2013. Such multiple divergences spread out over many months rarely end well, especially when red flags are beginning to proliferate all over the show. Risk in the stock market remains extremely high. Caveat emptor.
Charts by: StockCharts, Sentimentrader
Comments
Log in or sign up to join the conversation.