U.S. STOCKS ARE LOSING GROUND TO FOREIGN SHARES -- AN RSI ANALYSIS ALSO FAVORS FOREIGN STOCKS -- STOCK/BOND RATIO IS OVERBOUGHT AND STARTING TO WEAKEN -- STOCKS ARE WEAKENING VERSUS BONDS
U.S. STOCKS WEAKEN VERSUS FOREIGN STOCKS... My last message discussed how money was starting to rotate out of an over-extended U.S. stock market into foreign stocks which are trying to catch up to the U.S. market. This message will build on that theme by using ratio (or relative strength analysis). Chart 1 plots a ratio of the S&P 500 versus the EAFE iShares (EFA) over the last year. The EAFE represents developed foreign stocks in Europe, Australasis, and the Far East. After rising between January and June, the U.S./EAFE ratio peaked in July and has fallen since then. [The peak in the ratio coincided with peak in the U.S. dollar and a rally in foreign currencies, especially in Europe]. The ratio has also broken a rising support line drawn under its January/ May lows. That shows that the asset allocation pendulum has swung to foreign developed markets. We see a similar pattern in emerging markets. Chart 2 shows a ratio of the S&P 500 divided by Emerging Market iShares (EEM) having also broken a rising trendline going back to January. That suggests that some money is also rotating from the U.S. into riskier emerging markets.
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Chart 1
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Chart 2
APPLYING RSI LINE LINE TO U.S./FOREIGN STOCK RATIO... During a keynote speech at a Bloomberg conference in New York yesterday, I used a ratio to show the rotation described above from U.S. to foreign stocks. One of the attendees asked if I ever applied traditional technical indicators to ratio lines. Chart 3 shows how that can be done. The solid line is a ratio of the S&P 500 to the MS World Index ex USA ($MSWORLD) over the last decade. The falling ratio between 2002 and 2008 favored foreign stocks. [That was largely the result of a weaker U.S. dollar). Since 2008, the rising ratio has favored U.S. stocks (resulting largely from a stronger dollar). The 14-month RSI line (above chart) is applied to the U.S./foreign stock ratio. The RSI line hit oversold territory during 2006 and rose slightly until mid-2008. That created a "positive divergence" between it and the falling ratio. The RSI rose above the 50 line in mid-2008 which confirmed a major swing in favor of the U.S. The ratio recently hit the highest level in ten years. Notice, however, that the RSI line has formed a pattern of "lower peaks". That has created a "negative divergence" between it and the rising ratio (see diverging red lines). [A negative divergence exists when the RSI line starts dropping while a market index is still rising]. That divergence suggests that the pendulum is starting to swing in favor of foreign shares. [A weaker dollar since mid-year is contributing to the move into foreign shares].
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Chart 3
S&P 500/BOND RATIO IS ALSO OVERBOUGHT ... Let's apply the same RSI analysis to a ratio of stocks divided by bonds. The green line in Chart 4 plots a ratio of the S&P 500 divided by the 10-Year Treasury Note Price ($UST) since 2007. The red line is a 14-week RSI of that ratio. The main value of the RSI is to discover important overbought and oversold conditions in the stock/bond ratio. [RSI readings below 30 are oversold, while readings above 70 are overbought]. Since this a stock/bond ratio, oversold readings (below 30) suggest the start of a rotation out of bonds and into stocks. Those rotations into stocks occurred during 2008 and again in mid-2011. An overbought reading near the start of 2011 signalled a rotation out of stocks and into bonds that lasted until that summer. The rising ratio has favored stocks since then. After reaching overbought territory this summer, however, the RSI line has started to slip. That suggests the pendulum has swung too in favor of stocks and is beginning to favor bonds.
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Chart 4
STOCK/BOND RATIO IS WEAKENING... Chart 5 shows the 7-10 Year T-Bond Fund (IEF) rising over the last month as the S&P 500 has been slipping. The stock/bond ratio (top of chart) is starting to slip as well. So far, no serious damage has been done to stocks. The S&P 500, however, is in danger of slipping below its (blue) 50-day average which would weaken its short-term pattern. Given the problems in Washington, and an overbought U.S. stock market entering the dangerous month of October, some investors appear to be lightening up on stocks and moving some money into the safety of bonds and money market funds until the threat of a crisis has passed. Some of that money may also be moving overseas until the Washington stalemate is resolved.
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Chart 5
VIX IS RISING AGAIN ... The CBOE Volatility (VIX) Index hasn't done a great job of predicting market downturns over the last year. At the same time we can't ignore it. Upward spikes in the VIX during the first half of the year coincided with relatively modest stock corrections (the biggest one being a 7% drop during May and June). Even so, the ability of the VIX to rise above its September high raises the short-term risk for stocks (red circle). The first level of significant S&P chart support is its late August intra-day low at 1627 (a drop of 6% from its recent high).
