SMALL CAP/ LARGE CAP DIVERGENCE IS WORST IN THREE YEARS -- HIGH YIELD BOND WEAKNESS MAY ALSO BE CAUTION SIGNAL FOR STOCKS -- CHINA LEADS EMERGING MARKET BREAKOUT WHICH BOOSTS BASE METALS -- EUROZONE WEAKENS ON GLOBAL TENSIONS
SMALL CAP DIVERGENCE IS TROUBLING... Although the U.S. stock market has shown impressive resilience over the past few months, there are some troubling signs beneath the surface. One is the negative divergence between small caps and large caps. Since March 5, the S&P 500 Large Cap Index has gained more than 5%, while the Russell 2000 Small Cap Index has lost an equal amount. That negative 10% divergence is the biggest since 2011. The red line in Chart 1 plots a "ratio" of the Russell 2000 divided by the S&P 500. The black line is the S&P 500 by itself. Generally speaking, market rallies since 2009 have been led by small caps (a rising ratio). We saw that between 2009 and 2011, and again during 2012 and 2013. Chart 1 reveals at least two things. One is that the 2014 peak in the small cap/large cap ratio peaked around the same level as the 2011 peak. Second, that the ratio has fallen the most since 2011. Between May and October of that year, the S&P 500 fell 19% versus a 29% loss by the Russell 2000 (matching this year's divergence). Chart 2 shows the Russell 2000 trading in the middle of its 2014 trading range, and testing its 200-day moving average. As I suggested last Saturday, it may take a drop below its May low to signal more trouble for the broader market. That negative divergence, however, remains a caution sign.
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Chart 1
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Chart 2
JUNK BOND ALSO DIVERGE FROM STOCKS ... Another caution sign is coming from the bond market. Treasury bond prices hit a new 52-week high in a flight to safety, possibly from growing overseas tensions (more on that later). High yield government bonds (junk bonds), however, have had a bad July. The daily bars in Chart 3 show the iBoxx High Yield Corporate Bond iShares (HYG) falling during the first half of the month on rising volume. This week's bounce was turned back at its (blue) 50-day average, which is now acting as a resistance barrier (blue arrow). Junk bonds are the riskiest part of the fixed income space and are the most closely tied to the stock market. That July divergence between high yield bonds and the S&P 500 (black line) is another troubling divergence. That's because the two markets are highly correlated. Chart 4 show the two markets rising together over the last five years. The 50-week Correlation Coefficent (below chart) shows a positive correlation of .96 between the two. During 2011, both experienced large downside corrections. They've risen together since then -- until this month. That bears watching.
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Chart 3
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Chart 4
JUNK BONDS UNDERPERFORM TREASURIES ... The fact that high yield (junk) bonds are underperforming Treasuries is another cause for concern. That's because junk bonds are bought when investors are more optimistic on the economy, and Treasuries when they're more cautious. The green line in Chart 5 plots a "ratio" of the High Yield ETF (HYG) divided by the 20+Year T-Bond iShares (TLT) over the last four years. The chart shows that the S&P 500 (gray area) does better when the high yield/Treasury ratio is rising. The red circle to the right shows the ratio turning down this year (Treasuries have gained 15% versus a high yield gain of 4%). That's the biggest drop since 2012 (the last time the S&P 500 had a 10% correction). So far, it's nowhere near the big drop that took place during 2011 which resulted in an even bigger stock correction. But the fact that investors are rotating out of riskier junk bonds into safer Treasuries may be a caution sign for the stock market. They may be doing that for the same reason that they're rotating out of small cap stocks.
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Chart 5
CHINA LEADS EMERGING MARKET BREAKOUT... While developed markets struggled with global tensions (especially in Europe), emerging markets had a very good week. The weekly bars in Chart 6 shows Emerging Markets iShares (EEM) breaking out to the highest level in two years (see circle). The rising dotted line shows the EEM gaining ground on EAFE iShares this year. [EAFE iShares measure developed markets in Europe, Australasia and the Far East]. China was the main reason for that breakout. Chart 7 shows China iShares (FXI) also breaking out to the highest level in two years. [China is the biggest country in the EEM at 17%]. The blue bars in Chart 7 show Brazil iShares (EWZ) hitting a new 52-week high. [Brazil has an 11% weight in the EEM]. Both countries are closely tied to base metals which also had a strong week. China is the world's biggest user of those commodities and Brazil is one of the world's biggest exporters. The PowerShares Base Metals ETF (solid area) hit a six month high this past week as aluminum, copper, and zinc continued to rally.
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Chart 6
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Chart 7
EUROZONE HAS A BAD WEEK... A combination of week economic news, and close proximity to tensions in Ukraine, have weakened Eurozone assets. That can be seen in its common currency and their stocks. The green bars in Chart 8 show the Euro falling to the lowest level in eight months (green circle). Eurozone stocks also took a hit. The falling red line in Chart 8 plots a ratio of EMU Index iShares (EZU) divided by the S&P 500. Notice the close correlation between the falling Euro and the region's stocks. [During July, the EZU lost more than -4% while the SPX has held steady]. Most of the EMU losses came in bigger countries like France and Germany. The daily bars in Chart 9 show EMU iShares trading at a three-month low and testing their 200-day moving average. Needless to say, any further breakdown in that region could unsettle U.S. stocks
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Chart 8
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Chart 9
GOLD STOCKS OUTPACE STOCKS IN FACE OF RISING DOLLAR... Last Saturday's message wrote about how gold stocks were doing better than bullion for the first time in two years, which is generally a good sign for both. [I also pointed out the silver miners were even stronger]. The box in Chart 10 shows the Market Vectors Gold Mining ETF (GDX) consolidating during the week before jumping on Friday. To achieve a bullish breakout, however, the GDX still needs to clear its March high. What's especially impressive is that gold miners climbed in the face of a stronger dollar. The green bars above Chart 10 show the U.S. Dollar Index hitting a new five-month high on Friday (most of that gain came at the expense of the Euro). At the same time, gold stocks continue to outpace the S&P 500. That's shown by the rising GDX/SPX ratio (orange solid line). [So far this year, the GDX has outpaced the SPX by 20%]. Gold miners have also been the strongest stock market group this year. At least two intermarket factors usually drive money into precious metals. One is a weaker dollar, which we don't have at the moment. The other is fear of a stock market correction, possibly owing to some geopolitical shock somewhere in the world.
