SPX BREAKS BELOW 12-MONTH MOVING AVERAGE -- AUGUST MARKS 4TH CONSECUTIVE MONTHLY DECLINE -- EXCESSIVELY LOW SHORT-TERM YIELDS REFLECT UNCERTAINTY -- FALLING 10-YEAR YIELD IS BEARISH FOR STOCKS -- STEEPENING YIELD CURVE POINTS TO QE3

SPX BREAKS BELOW 12-MONTH MOVING AVERAGE... Link for todays video. Long-term signals require long-term charts. Chart 1 shows monthly bars for the S&P 500 and the 12-period simple moving average. Over the last 17 years, there were five good crosses (signals) and at least two whipsaws (blue ovals). It is interesting to note that the whipsaws occurred after steep two month declines that were quickly erased (Sep-1998 and Jun-2010). Most recently, the S&P 500 moved below its 12-period SMA with a close below 1270 this month. Today is August 31st and the index is trading near 1223. There is little chance we will see a close above 1270 by the end of today (+3.85%). This means August will mark the fourth straight monthly decline and the index will close below its 12-period SMA. There is always the chance that this cross will result in a whipsaw, but this signal remains bearish until proven otherwise with a monthly close back above the moving average.

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Chart 1

Moving average signals can be further filtered with another indicator. The indicator window shows 12-period Aroon. Aroon (Up) is green and Aroon (Down) is red. A surge to 100 signals the start of a new trend emerging (red/green arrows). Using Aroon as a filter, the moving average crosses in September 1998 and June 2010 would be ignored. In both cases, Aroon (Up) triggered a bullish signal months before and this signal had yet to be countered with a bearish signal. The Aroon bullish signals in mid 2003 and late 2009 occurred after the moving average crossover. There is sometimes a delay or lag with the confirming signal. Most recently, Aroon (Up) remains on a bullish signal. Despite the August plunge, Aroon (Down) has yet to surge. A move to 100 in Aroon (Down) would confirm the bearish moving average cross. Click here for Aroon in ChartSchool

AUGUST MARKS 4TH CONSECUTIVE MONTHLY DECLINE ... Chart 2 shows candlesticks for the S&P 500 ETF (SPY) over the last seven years. The blue line is the 12-month SMA. When studying this chart, I was struck by the similarity between the January 2008 breakdown candlestick and the August 2011 breakdown candlestick. Both candlesticks broke below the 12-month moving average with above average volume. Both formed long lower shadows and filled red bodies. The body is filled when the monthly close is below the monthly open. The candlestick is red because the August close is below the September (prior) close. The long lower shadows show the ability to recover after a moving average break. However, the ETF never closed back above the 12-period moving average. This is key. There was an oversold bounce in early 2008, but notice how the moving average turned into resistance in May 2008 (red arrow). It is also worth noting that SPY will be down four consecutive months by the close today. February 2008 was the last time this happened.

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Chart 2

EXCESSIVELY LOW SHORT-TERM YIELDS REFLECT UNCERTAINTY... Treasury yields remain below their 2008 lows and this suggests continued uncertainty in the financial system. Chart 3 shows the S&P 500 (red) with an array of Treasury yields. In general, yields were moving higher from 2004 to 2006. There was a peak in 2007 and a sharp decline in 2008 as the financial crisis hit. Yields moved below their 2003 lows as money moved into Treasuries as for safe haven. Even though the stock market bottomed in March 2009 and the S&P 500 advanced until July 2011, Treasury yields remained in a downtrend. The red dotted lines with the arrows show downtrends from 2009 to the present. In fact, short-term yields dropped below one tenth of one percent this month (3-month T-Bills and 1-year T-Notes). This yield is next-to-nothing. While such low yields may push money into the stock market, these low yields do not show confidence in the economy or the financial system. Yields would be much higher if the economy and financial system were on a sound footing. 2005 and 2006 marked the last time the Treasury market showed real confidence.

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Chart 3

FALLING 10-YEAR YIELD IS BEARISH FOR STOCKS... The stock market remains positively correlated to the 10-year Treasury Yield. Chart 4 shows the S&P 500 (black) with the 10-year Treasury Yield (red) in the main window. Overall, there is a positive correlation between the 10-year Treasury Yield and the S&P 500. The indicator window shows the 63-day Correlation Coefficient, which covers around three months. There are dips into negative territory, but the correlation is clearly more positive than negative. Turning back to the main window, two things matter when it comes to the 10-year Treasury Yield: direction and level. A relatively high yield or a rising yield is positive for the stock market. A relatively low yield or a falling yield is negative for the stock market. 3% seems to be the line in the sand. Anything above 3% is relatively high and shows some confidence. Anything below 3% is relatively low and shows uncertainty. The 10-year Treasury Yield peaked in February, broke 3% in June and fell off a cliff the last two months. This means it is both low and falling. A sharp upside reversal is needed to turn this indicator bullish for stocks again. The blue arrows show prior upside reversals that benefited stocks.

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Chart 4

STEEPENING YIELD CURVE POINTS TO QE3 ANNOUNCEMENT... Fed policy has been and continues to be in the spotlight. First, eyes were focused on the Feds Jackson Hole meeting. Second, attention turned to the release of the Fed minutes on Tuesday. Third, attention is now focused on the next Fed meeting (Sept 20-21). While Fed watchers wait for lagging clues, the bond market has already made its move with a serious steepening of the yield curve. The ratio between the 10-year Treasury Yield and 2-Year Treasury Yield surged to its highest level in more than 20 years. Currently, the 10-year Treasury Yield (2.19%) is more than ten times the 2-Year Treasury Yield (.20%). A ratio of 1 means both yields are equal and the yield curve is flat. This curve is anything but flat. Looking back, there is clearly a connection between quantitative easing announcements and this 10YR:2YR ratio. First, the ratio steepened significantly ahead of the QE1 announcement on November 25th 2008. Second, the ratio again steepened significantly ahead of the QE2 announcement on November 3 2010, two years later. Here we are in August 2011 and the ratio is again steepening significantly. It looks like the bond market is betting on a QE3 announcement at the September meeting.

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Chart 5

While a steep yield curve benefits banks, such a sharp steepening reflects uncertainty in the financial system and/or the economy. Banks make money by borrowing at short-term rates and lending at long-term rates, provided there is enough lending going on. Both the 10-year Treasury Yield and 2-Year Treasury Yield are falling, but short-term yields are falling at a faster rate than long-term yields. This is causing the yield curve to steepen. Money is seeking refuge from uncertainty by moving into short-term Treasuries, which already yield next-to-nothing. No wonder the Fed is worried.