TREASURY BONDS SIGNAL MORE CAUTION ON THE ECONOMY -- INVESTORS MAY START FAVORING SAFER TREASURIES OVER RISKIER JUNK BONDS -- MORE ON MACD LINES -- % NYSE STOCKS OVER 50-DAY AVG WEAKENS -- ABBOTT LABS TOP HEALTH CARE GAINER
BREAKDOWN IN BOND YIELD MAY BE BAD FOR STOCKS ... One of the catalysts behind Thursdays heavy stock selling was the breakdown in Treasury bond yields. The 10-Year T-note yield fell below its July low to the lowest level in more than four months. Bond yields are an indicator of confidence in the economy. When investors are optimistic, they buy stocks and sell Treasuries. That pushes bond yields higher. When they're more pessimistic, they sell stocks and buy Treasuries. That pushes yields lower. So the direction of Treasury bond yields has some bearing on the direction of stocks. That's been especially true over the last two years. The weekly bars in Chart 1 compare the trend of the 10 Year Treasury Note Yield (TNX) to the S&P 500 (green line). At least two things are apparent. One is that bond yields and stocks have usually trended in the same direction. The second is that bond yields have tended to change direction first. Bond yields started dropping during the summer of 2007 several months before stocks peaked. Bond yields started bouncing at the start of 2008 and anticipated a stock rebound that spring. After falling together during the second half of last year, bond yields turned up several months before stocks. Chart 2 shows bond yields turning up in January of this year two months before stocks' March bottom. Bond yields peaked in June, however, and have been weakening since then while stock prices have risen. That "negative intermarket divergence" grew more serious with yesterday's breakdown in yields.
Chart 1
Chart 2
COMPARING TREASURIES TO JUNK ... One of our readers asked whether Treasury prices or junk bonds gave better warnings. I think it's better to use both of them together. Investors buy high-yield (junk) bonds when they're more optimistic and Treasuries when they're less so. In fact, both are giving warning signals at the moment. Chart 3 shows the 7-10 Year Treasury Bond ETF (IEF) breaking out to the upside on Thursday on strong volume. Chart 4 shows the Lehman High Bond ETF (JNK) falling on heavy volume. Both of those trends show more investor caution. [Investment grade corporate bonds also fell heavily on strong volume]. If Treasury prices continue to rise, and junk bonds drop, that would be a more serious warning on the economy and stocks. It's also useful to compare the two bond classes. Chart 5 is ratio of JNK to the IEF. Junk bonds underperformed Treasuries during the second half of 2008 (when stocks were falling), but bottomed in March (along with stocks) and has been rising faster than treasuries since then. In other words, investors favor Treasuries when stocks are weak and embrace junk bonds when stocks are rising. Chart 6 gives a closer view of the JNK:IEF ratio. This week's sharp drop in the ratio is an initial warning of investor nervousness. A drop below the September low would be a more serious warning that investors are starting to abandon risker corporate bonds and starting to favor safer Treasuries.
Chart 3
Chart 4
Chart 5
Chart 6
MORE ON MACD ... I received a number of questions on last Friday's MACD article. I'll try to answer some of them. First of all, the default values for all MACD lines (hourly, daily, weekly, monthly) are 12, 26, and 9. It uses the same numbers in all time dimensions. They automatically appear when you choose that indicator (but you change them if you wish). One reader asked about crossings of the zero line. That's a slower signal, but worth watching for. Chart 7 shows the daily MACD lines crossing above their zero line during March and again in mid-July. Bear market rallies usually find resistance around the zero line while bull market pullbacks usually find support there. Short-term violations (as in July) usually don't last long. For a more serious sell signal to appear, the daily MACD lines would not only have to fall below their zero line but their July low as well. Chart 8 shows weekly MACD lines on top of S&P 500 price bars. A bullish crossing took place in March which is still intact. [The weekly MACD lines crossed above their zero line at the start of July for the first time in eighteen months]. Although they're still positive, the distance between them is narrowing (as shown by the histogram bars). What that means is that the major trend is still up, but some loss of upside momentum is evident. As I suggested last week, short-term traders should pay more attention to daily signals, while longer-term investors should concentrate on the weekly lines.
Chart 7
Chart 8
ANOTHER WARNING SIGN... Last Friday I showed the % of NYSE stocks trading over their 50-day averages to be in very overbought territory near 90. I pointed out, however, that the indicator needed to start dropping to issue a short-term warning signal. Chart 9 shows the indicator having fallen below its August/September low near 74. The last time that happened was in June when the market suffered a 9% correction that lasted about a month. What makes this downturn a bit more serious that it also constitutes a "negative divergence" from rising stock prices. Chart 10 shows a point & figure chart of the % NYSE stocks trading over their 200-day moving averages which tells us more about the market's major trend. Readings over 50 indicate a bull market market in force. Readings over 90%, however, show a very overbought market. The chart has given a number excellent buy signals since the March bottom. [A p&f buy signal occurs when a rising X column exceeds a previous X column]. An initial sign of a possible top would be a three-box reversal into a zero line. Since each box is worth 2 points on this chart, that would require a drop to 86. While the 50-day indicator has turned down, the 200-day one has yet to do so. But it's stretched pretty far.
Chart 9
Chart 10
VIX BOUNCES WHILE STOCKS DROP ... The CBOE Volatility (VIX) Index trends in the opposite direction of the stock market. That's why we follow for clues about market direction. The VIX peaked in March (when the market bottomed) and has fallen since then. This week's bounce put it right up against its early September intra-day peak at 29.57. [Today's intra-day high was 29.56]. The VIX is worth watching at this point. A decisive close above 30 would turn its short-term trend higher and would most likely lead to lower stock prices. Meanwhile, stocks suffered their second down week in a row. This week's price drop also saw heavier volume as shown in the S&P 500 SPDRs in Chart 12. That's not a good sign. After slipping below initial support at 104 (the late August high), the SPY is testing its 50-day moving average at 102. A close below that line would signal a drop to its August/September low. The fact that we've entered the dangerous month of October may also have some traders and investors on edge. That also explains why money has been rotating out of economically-sensitive stocks to defensive groups like consumer staples and healthcare.
Chart 11
Chart 12
GOING ON DEFENSE ... I expressed the view last Friday that the fact that some money was starting to flow into defensive groups like consumer staples and healthcare was a sign that investors were getting nervous. Both groups held up relatively this week in the face of a weak market. Abbott Labs (which I showed last Friday) was the top healthcare gainer (+5%). Its chart shows a bullish breakaway gap on Monday on rising volume. Friday's strong close appears to have confirmed that bullish breakout. Its relative strength ratio (solid line) has started rising for the first time since March. Consumer staples were the only sector to end the week in the black. Chart 14 shows the Fidelity Select Consumer Staples Fund (through Thursday) which was the week's top gainer. Its relative strength ratio (solid line) is also starting to recover. The RS line peaked in March when the market bottomed. The fact that it's starting to rise is another caution sign for the rest of the market.
Chart 13
Chart 14
GOLD HOLDS SUPPORT ... Gold's defensive qualities also provided support this week. Chart 15 shows the streetTracks Gold ETF (GLD) finding initial support along its June high near 97. There's even stronger support along its August high near 95. Remember that gold is not only a key commodity; it's also viewed by many as an alternate currency. It also tends to do well when interest rates are falling and investors are looking for an alternative to stocks. Lack of confidence in the U.S. Dollar is another plus for the yellow metal.
Chart 15
