GERMANY LEADS REST OF THE WORLD INTO DOWNSIDE CORRECTION -- A LOT OF MOVING AVERAGES HAVE BEEN BROKEN -- BOND YIELDS FALL AT WEEK'S END -- RISING DOLLAR HAS CONTRIBUTED TO COMMODITY SELLOFF -- % NYSE STOCKS ABOVE 50 AND 200-DAY AVERAGES PLUNGES
GERMAN DAX FALLS BELOW 200-DAY AVERAGE... My last two messages warned that weakness in the Eurozone threatened the global rally in stocks, including the U.S. Not surprisingly, this week's plunge in Europe finally had a negative impact on most other developed markets. Chart 1 shows EMU iShares (EZU) falling below its 200-day moving average. And it did so on rising volume. That's the first time the index of Eurozone stocks has fallen below that long-term support line in a year. [The EZU is a basket of Eurozone stocks with the biggest holdings in France and Germany]. Germany is the biggest economy in Europe and has a big influence on that region. So it's not good news to see the German DAX Index falling below its 200-day line this week as well (Chart 2). That's the first time the DAX has ended the week below that long-term support line in two years. Chart 3 shows the French CAC Index doing the same. That breakdown finally took its toll on U.S. stocks which were already showing a number of negative divergences.
(click to view a live version of this chart)
Chart 1
(click to view a live version of this chart)
Chart 2
(click to view a live version of this chart)
Chart 3
RUSSELL 2000 INDEX BREAKS ITS 200-DAY LINE... Last Saturday's message explained that the negative divergence between U.S. small cap and large cap stocks was at the widest since 2011. It also showed the Russell 2000 Small Cap Index testing its 200-day average. Chart 4 shows the RUT falling below that support line pretty decisively this week. It now appears headed for a test of its May low. A drop below that level would be a lot more serious for it and the rest of the market.
(click to view a live version of this chart)
Chart 4
HIGH YIELD BONDS CONTINUE TO PLUNGE... Another recent warning has come from heavy selling in high-yield (junk) bonds. Chart 6 shows the iBoxx High Yield Corporate Bond iShares (HYG) plunging again this week to their 200-day moving average (in heavy trading). That's the biggest loss since the spring of 2013. Last Saturday's message shows the HYG falling below its 50-day line, and suggested that selling in high-yield bonds (and small caps) was an early warning that investors were leaving the riskiest parts of the bond and stock markets (which are usually the first to peak). That earlier message also pointed out that stocks and junk bonds are highly correlated. Weakness in one (junk bonds) usually warns of weakness in the other (stocks). Another warning sign was the fact that junk bonds were underperforming Treasuries by the widest margin in two years. That's another sign that investors were moving out of riskier bonds into safer ones.
(click to view a live version of this chart)
Chart 5
BOND YIELD REMAINS WEAK ... Bonds had an interesting week. They jumped on Wednesday on the report that second quarter GDP growth had climbed 4%. And on Thursday on a report that labor costs were climbing. Signs of economic strength (and wage inflation) usually boost bond yields. Yields, however, fell sharply on Friday on a disappoingting jobs report. Heavy stock selling also pushed money into safe haven Treasuries on Friday which also pulled bond yields lower. Chart 6 shows the 10-Year Treasury Note Yield (TNX) ending the week about where it began at 2.50%. The chart shows the TNX still well below its 200-day average (red line) and still in a downtrend. Another factor weighing on Treasury yields is the fact that yields in the Eurozone and Japan are even lower. I suggested on Wednesday that the higher relative yields in the U.S. made them a more attractive alternative to fixed income investors. It's very difficult for Treasury bond yields to rise in isolation. Like global stocks, global bonds in developed markets are highly correlated. Eurozone inflation came in this week at 0.4% which is the lowest in four years. That increases the likelihood for even more monetary easing in Europe (possibly even a bond buying program), which would push bond yields even lower. German yields are already at the lowest level in history. A downside correction in global stocks would also push bond prices higher and yields lower.
(click to view a live version of this chart)
Chart 6
AGRICULTURE AND ENERGY LEAD COMMODITIES LOWER ... After a strong first half, commodity prices are coming under a lot of selling pressure. Two of the hardest hit groups are agriculture and energy. The brown bars in Chart 7 show the PowerShares Agriculural ETF (DBA) peaking in late April and tumbling to the lowest level since February. Those losses were due mainly to good growing conditions which pushed grains and cotton sharply lower. The black line in Chart 7 shows the PowerShares Energy ETF (DBE) peaking in late June and tumbling to the lowest level since April. Crude oil dropped from $107 a barrel to $97 during that period, nearly a 10% loss. One of the side effects of falling food and energy prices is keeping inflation at a lower level, which also has a depressing effect on bond yields. [Industrial metals held up much better than other commodities during that period]. A rising dollar is another reason for the commodity selloff.
(click to view a live version of this chart)
Chart 7
RISING DOLLAR PUSHES COMMODITIES LOWER ... On Wednesday, I wrote about the rising U.S. Dollar putting downside pressure on gold. The same is true for commodities in general. One of the most consistent intermarket relationships is the inverse relationship between commodities and the dollar. Chart 8 demonstrates that by comparing the CRB Index of nineteen commodity markets (brown area) compared to the U.S. Dollar Index (green line). They clearly moved in opposites directions during 2014. The first four months of the year show a falling dollar coinciding with rising commodities. A dollar bottom in early May stopped the commodity rally. A second (and higher) dollar bottom in early July finally caused commodity prices to tumble. At the moment, the CRB Index is trading at the lowest level in six months, while the USD has reached a 10-month high. The 60-day Correlation Coefficient (below chart) has shown negative correlation (below the zero line) all year. The dollar rally may be predicated on the belief that U.S. rates will rise faster than foreign rates over the next year (or that foreign rates will decline more than the U.S.). The fact that U.S. bond yields are higher than those in the Eurozone and Japan also makes the dollar a stronger bet than the Euro or the yen. The Euro is trading at an eight-month low. A big drop in the yen this week also boosted the dollar (but helped Japanese stocks).
(click to view a live version of this chart)
Chart 8
S&P 500 FALLS BELOW 50-DAY AVERAGE... All the negative divergences pointed out earlier, combined with heavy selling in Europe, finally pushed U.S. stocks into a downside correction. The daily bars in Chart 9 show the S&P 500 falling below its (blue) 50-day average for the first time since April (and in heavy trading). That turned the market's short-term trend lower. How much lower remains to be seen. The next potential support level for the SPX is its spring high just below 1900. A more serious pullback could bring it all the way to its (red) 200-day line. So far, damage to the SPX has been relatively minor. That's not true, however, for the rest of the market. The blue line above Chart 9 shows that the % of NYSE stocks above their 50-day average has plunged from 80% at the start of July to below 30% on Friday. That's even weaker than the lowest reading during February. Even more concerning is the fact that the % of NYSE stocks trading above their 200-day average has plunged from 80% to 59% in the short span of a month. That's the lowest reading since February. It also means that 40% of NYSE stocks are in major downtrends. Considering that August and September are usually two of the year's weakest months (pointed out by Arthur Hill), that raises more serious concerns about the market's short to intermediate term outlook.
(click to view a live version of this chart)
Chart 9
VIX JUMPS TO FOUR-MONTH HIGH ... As usually happens when stocks weaken, the CBOE Volatility (VIX) Index jumped sharply this week to the highest level since April. The VIX (also called the "fear gauge") has climbed 47% since the start of July. That means that traders are buying "option" insurance against a possible downturn in stocks. The red bars in Chart 10 show that the recent upturn in the VIX is the biggest since January. That's consistent with a short-term correction. A move above its spring highs, however, (18.22 and 17.85) would be more cause for concern. Generally speaking, VIX closes much above 20 often signal a major downside stock correction, while moves above 40 usually mark major bottoms. The last time a decisive VIX move above 20 triggered a major correction was between July and October 2011, when the S&P 500 lost nearly 20%. Stocks bottomed that October with the VIX peaking at 48. [I pointed out earlier this year that downside corrections ending in October are also common during midterm election years -- like 2014]. That doesn't guarantee that a similar pattern will form this year, but seasonal and historical tendencies shouldn't be ignored. To quote Mark Twain: "History doesn't repeat itself, but it rhymes."
