FOREIGN STOCK ETFS ARE TESTING MAJOR OVERHEAD RESISTANCE BARRIERS WHICH COULD THREATEN GLOBAL RALLY -- THE % NYSE STOCKS ABOVE 200-DAY AVERAGE HAS FALLEN TO 2014 LOW -- SMALL CAP RELATIVE WEAKNESS IS WORST IN THREE YEARS
THE STOCK RALLY IS GETTING NARROWER... Arthur Hill wrote about the negative divergence between small and micap stocks relative to large cap stocks. Let's put that in some perspective. Chart 1 shows that the three stock categories have been rising together since the 2009 bottom (as they usually do). During those five plus years, the S&P 500 Midcap Index (MID) was the leader with a gain of 158%. The Russell 2000 Small Cap Index (RUT) came in second with a gain of 124%. The S&P 500 Large Cap Index ($SPX) came in third with a five year gain of 119%. Chart 2 shows their relative performance more clearly by plotting the two smaller stock indexes relative to the S&P 500 (flat black line). Since the start of 2014, the falling red line shows small caps lagging behind large caps by the widest margin in three years. The falling blue line shows that midcaps are starting to underperform large caps as well. The midcap divergence is the worst in two years. What that means is that the stock market rally is getting narrower. In other words, fewer stocks are participating in the uptrend. That's normally an early warning of a possible correction. Major stock indexes have recently hit new highs. Large cap indexes like the S&P 500, however, are capitalization weighted, which means they're dominated by large cap stocks. That's why large cap indexes are usually the last to roll over. We may be getting close to that possibility -- especially in the middle of the seasonally dangerous September-October period. The situation will get a lot more serious if and when the Russell 2000 falls below chart support along its May/August lows.
Chart 1
Chart 2
FOREIGN DIVERGENCES EXIST AS WELL... The fact that foreign stock indexes are testing major overhead resistance barriers puts them at an important chart juncture, and adds to the possibility of a global stock pullback -- which would include the U.S. The monthly bars in Chart 3 show EAFE Index iShares (EFA) starting to back off from a test of its 2007 peak. Most of the recent selling in that index of foreign developed markets has come from Europe. Australia has started to roll over as well on weakness in commodity markets and fears of a slowdown in China. Although the S&P 500 recently hit a record high (with the U.S. remaining the strongest stock market in the world), it usually does better when foreign shares are rising along with it. Emerging markets are undergoing a major test of their own. The monthly bars in Chart 4 show the Emerging Markets iShares (EEM) backing off from a major resistance line drawn over its 2007 and 2011 highs. Recent concerns about weakness in China (and weak commodity prices) have weighed on Chinese and Brazilian stocks. Expectations for rising U.S. interest rates, and a stronger U.S. dollar, could also put downside pressure on emerging markets by reducing flows into their higher-yielding markets. The September slide in the EEM has coincided with a bounce in the 10-Year Treasury yield.
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Chart 3
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Chart 4
NYSE PERCENT OF STOCKS ABOVE 50-DAY AVERAGE IS FALLING... Within the U.S. market, another sign that upside participation is narrowing can be seen in the falling NYSE Percent of Stocks Above their 50-Day Moving Average. The blue line in Chart 5 shows that percent fallng to 30%. That index peaked over 80% in late June. Its August rally only took it 65%, which was well below its summer high. At the same time, the S&P 500 (gray area) recently hit a new record high. The late August divergence between the blue and gray lines is one of the worst since the bull market started more than five years ago. The situation is even worse with the 200-day average.
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Chart 5
% NYSE STOCKS ABOVE 200-DAY AVERAGE FALLS TO YEARLY LOW... The red line in Chart 6 shows the NYSE Percent of Stocks above their 200-day Moving Average falling to 53% and, in so doing, has undercut its February low. That index peaked near 80% in early July and fell to 58% during August. Its September rebound rose to 70%, which was well below its summer peak. That negative divergence between it and the record high S&P 500 has since gotten a lot worse. Chart 7 shows that the index has not only fallen to the lowest level in a year, it has broken a rising support line extending back to mid-2012. That means that nearly half of NYSE stocks are now below their 200-day averages. That's hardly the definition of a strong bull market.
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Chart 6
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Chart 7
NO EMA DEATH CROSS... Several analysts have recently expressed concern that the Russell 2000 has suffered a "death cross", which occurs when the 50-day moving average falls below its 200-day as it did this week (not shown here). The last time that happened was in the summer of 2011 in the midst of a downside correction that lasted from May to October. The two averages turned positive at the start of 2012 and remained positive -- until this week. When it comes to moving average crossovers, I prefer to use exponential averages. I've always found EMA crossings to be more reliable. Chart 8 shows that the 50-day EMA is still well above its 200-day EMA. I'll become more concerned if and when the blue EMA falls below the red EMA line. So far, that hasn't happened. In addition, the daily bars show that the Russell 2000 Small Cap Index remains above its May/August lows. As long as that remains the case, its sideways pattern may not present a major threat to the rest of the market. A downside violation of those lows would. So would an EMA "death cross".
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Chart 8
HEDGING OUT THE FALLING EURO ... A falling currency hurts the relative performance of a country or region's stock ETF. That's because foreign stock ETFs are quoted in U.S. dollars. As a result, dollar-demoninated stock ETFs are weaker when the dollar is stronger than the local currency. American investors who buy foreign stocks also buy the local currency. A falling foreign currency, therefore, substracts from any local stock gains, or makes any stock losses even bigger. I recently explained why it was important for investors in Japan to use an ETF that hedges out the negative effects of a falling yen. The same can be said for Europe. The Euro has plunged -7.5% since May and is trading at the lowest level in 14 months. That has hurt eurozone stock ETFs. Chart 9 shows the EMU Index iShares (which represent eurozone stocks) trading below its 50-and 200-day averages (and roughly 9% off its June high). By comparison, Chart 10 shows the Wisdom Tree Europe Hedged Equity Fund (HEDJ) trading well above its moving average lines (and down less than 2% from its June high). That 7% difference between the two ETFs is the negative Euro effect. The HEDJ hedges out the negative effect of the falling Euro, and favors exporters that benefit from the weaker currency. I'm not suggesting that Europe is a buy at this point. But if you're thinking about putting some money into the eurozone, be sure to use a vehicle that hedges out the negative effect of a weaker Euro.
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Chart 9
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Chart 10
MARKET BOUNCES ON GOOD HOUSING NEWS ... Stocks experienced a nice bounce today. Charts 11 and 12 show the Dow Diamonds and S&P 500 SPDRs climbing nearly 1% on the day. That's enough to keep both indexes above initial chart support along their September lows and 50-day moving averages. A report that August new home sales hit a six-year high cheered the market (although homebuilders didn't react much). So did big gains in Bed Bath & Beyond (7%) and Wal Mart (2%). Biotechs led a healthcare bounce of 1.6%. Consumer discretionary stocks gained more than 1% as well. The Russell 2000 also bounced. The dollar hit another recovery high and bond yields bounced. The CBOE Volatility (VIX) Index fell 10%.
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Chart 11
