10-YEAR T-NOTE YIELD FALLS TO SEVEN MONTH LOW -- THAT'S ANOTHER NEGATIVE DIVERGENCE FOR STOCKS -- ANOTHER NEGATIVE WARNING IS THAT HIGH YIELD BONDS ARE UNDERPERFORMING TREASURIES -- SMALL CAP WEAKNESS CONTINUES TO WEIGH ON MARKET
10-YEAR TREASURY YIELDS FALL TO SEVEN-MONTH LOW... Chart 1 shows the 10-Year Treasury Note Yield (TNX) falling below its early February low in today's trading. That puts the TNX at the lowest level since last October. Normally, a falling bond yield signals that investors are turning more pessimistic on the economy. That seems strange considering that the Dow and S&P 500 have just hit record highs. The discrepancy between falling bond yields and rising stock prices is just another sign that the recent large cap rally may not be as strong as it appears. Chart 2 shows the divergence between the falling Treasury yield and a rising S&P 500. The downturn in bond yields in January coincided with a pullback in stock prices. Both then stabilized at the start of February. Since the start of April, however, falling bond yields have diverged from a rising SPX. Today's breakdown in bond yields makes their divergence even more striking. Something seems wrong here. One of the two markets is sending the wrong message. The question is which one.
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Chart 1
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Chart 2
SMALL CAPS FALL WITH BOND YIELDS ... Chart 3 shows the 10-Year T-Note yield falling since early March along with the Russell 2000 Small Cap Index. Generally speaking, small caps are more sensitive to turns in the economy than large caps. Which means smaller stocks are quicker to sense economic weakness. If small caps are used in place of large caps, the divergence between bonds and stocks since the start of March virtually disappears. It's possible that bond investors are more focused on warning signs from small caps, momentum stocks in the biotech and social media groups, and growth stocks in general that have lagged behind large cap blue chips stocks since the start of March. Not only has money rotated out of those weaker stock groups into larger and safer value stocks, but some of that nervous money has also been moving into bonds. Virtually every bond category has outperformed the S&P 500 since the start of the year. Interestingly, the worst bond performer since the start of 2014 has been high yield bonds. That may also be sending a warning.
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Chart 3
HIGH YIELDS BONDS ARE LAGGING BEHIND TREASURIES ... High yield corporate bonds are more closely tied to stocks than bonds. When stocks are strong, high yield corporates do better than Treasury bonds. That's especially true if bond yields are rising. When bond yields start to fall, fixed income investors favor longer Treasury bond maturities. Relative weakness in high yield bonds is often a warning of weaker stock prices. Chart 4 compares weekly S&P 500 price bars to a "ratio" of High Yield Corporate Bond iShares (HYG) divided by 20+ Year Treasury Bond iShares (TLT) since 2007. The chart shows a generally positive correlation between the two lines. When stocks are weak (like 2008 and 2011) high yield bonds underperform Treasuries (a falling ratio). When stocks are rising (2009 through 2010 and the two years since spring 2012), high yield outperforms Treasuries (rising ratio). Chart 5 compares the same two lines over the last year. After rising throughout 2013 (along with stocks), the high yield/ Treasury bond ratio has been falling since January. Both have risen, but Treasuries have risen faster. The TLT is the strongest bond category with a 2014 gain of 12%. The HYG is the weakest 2014 bond performer with a gain of 3.7%. The S&P 500, by comparison, has gained 2.2% while small caps have lost -5%. Add Chart 5 to the list of negative divergences between bonds and stocks.
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Chart 4
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Chart 5
DIVERGENCE BETWEEN SMALL AND LARGE CAPS CONTINUES... Small caps and large cap stocks usually trend in the same direction. They may take turns leading the market higher or lower, but they generally move up and down together. Since the 2009 bottom, their 50-week Correlation Coefficient has been a very high .92. The daily bars in Chart 6 shows them diverging from each other over the last two and half months. While the S&P 500 has gained 1.5% since March 1, the Russell 2000 Small Cap Index has lost -6.6%. [The Nasdaq Composite has fallen nearly -5%]. The black line below Chart 6 shows the 60-day Correlation Coefficient falling to zero over the last month. That's the lowest correlation I've found between the the two indexes in more than a decade. So it's very unusual. It's hard to imagine the S&P 500 Large Cap Index continuing to rise while small caps are falling. And they are. Chart 6 shows the small cap index falling sharply today and falling back below its 200-day moving average. It may be headed for another test of its early February low. In my view, the direction of the Russell 2000 Small Cap Index from here should tell us more about market direction than the S&P 500. Maybe bond investors are looking at the same chart.
