RISING RATES HURT EMERGING MARKETS -- SMALL CAPS HAVE LOST MARKET LEADERSHIP

EMERGING MARKETS ARE FALLING HARD ... Given the high correlation between global stock markets, it's no surprise to see most of them weakening along with the U.S. market. Emerging markets are getting hit especially hard. I believe that's due to the recent upturn in long-term rates. As global markets turn more defensive, it's reasonable to expect the riskiest to fall the hardest. Recent selling in emerging markets also explains downturns in Asia and Latin American markets. Chart 1 shows the Emerging Markets iShares (EEM) over the last five months. At the end of February, the EEM was hitting a new high and outperforming the U.S. market. Since then, it's fallen below its 50-day average. And its relative line (versus the S&P 500) has started to drop. Part of that is coming from a stronger dollar which hurts global ETFs. I believe some of it is also coming from rising U.S. bond yields.

Chart 1

RATES VS. EMERGING MARKETS ... The dark line in Chart 2 is a ratio of the Emerging Markets ETF divided by the S&P 500 over the last year. It's intended to show how emerging markets have done relative to the U.S. market. The red line is the 10-year T-Note yield. There appears to be an inverse correlation between the two. The EEM/SPX ratio fell sharply from last April to June just as bond yields started to spike higher. That meant that rising bond yields hurt emerging markets more than the U.S. market last spring. As rates fell during the second half of last year, emerging markets assumed their leadership role. It wasn't until bond yields spiked again during March that emerging markets started to do worse than the U.S. market. That tells me that global investors are turning more defensive and are starting to sell riskier investments. I like to think of emerging markets as global small cap stocks. They tend to lead on the upside when things are going good; but they fall harder when things start to go bad.

Chart 2

RUSSELL 2000 SHOWS RELATIVE WEAKNESS... The Russell 2000 Small Cap Index has been underperforming large cap stocks since last December. That's not necessarily a good sign for the market. That's because small cap stocks had been leading it higher. The first real negative divergence took place at the start of March when the RUT fell short of its December peak as the S&P 500 hit a multi-year high (see arrows). The Russell is now threatening its January low and its 200-day moving average and is the weakest of the market indexes. That strikes me as another sign that the market is starting to sell off more speculative issues.

Chart 3

SMALL CAPS LEADING S&P 500 LOWER... The daily bars in Chart 3 show the S&P 500 Large Cap Index. The solid line is a ratio of the Russell 2000 Small Cap Index divided by the SPX. It's easy to see on this chart that the small cap/largecap ratio peaked at the end of December and has been falling since then. Several months ago I wrote that large caps usually follow small caps higher. Unfortunately, they also follow small caps lower as well. Like they're doing now. Both are approaching a crucial test of their late-January low.

Chart 4