STRONG JOBS REPORT PUSHES BOND YIELDS AND DOLLAR HIGHER -- RISING DOLLAR MAY BE HELPING SMALL CAPS TO PLAY CATCHUP -- RISING RATES HELP BANKS, BROKERS, AND INSURERS -- BUT HURT UTILITIES AND REITS -- RISING BOND YIELDS FAVOR CYCLICALS OVER STAPLES
STOCKS END THE WEEK MIXED, BUT STILL IN UPTREND... Friday's jobs report caused some minor profit-taking in major stock indexes, but not enough to alter the current uptrend. Chart 1 shows the S&P 500 dropping slightly Wednesday through Friday (but closing up for the week). I've pointed out that stocks are up against chart resistance along their summer highs and in a short-term overbought condition. That could lead to some backing and filling like we saw this week, but nothing too serious. The longer range trend remains positive. Initial chart support for the SPX is at 2060 which coincides with its rising 200-day moving average. Friday's mixed results for major stock indexes, however, masked big sector rotations beneath the surface. That was due mainly to the big jump in bond yields and its effect on various stock groups. It helped banks, brokers, and insurers, but hurt utilities, REITS, and dividend-paying consumer staples. The resulting jump in the U.S. dollar also had a bearish effect on gold miners and other commodity stocks. The rising dollar may also have contributed to this week's jump in small cap stocks which are starting to play catch up.
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Chart 1
SMALL CAPS ARE CATCHING UP ... Last weekend's message wrote about the tendency for small cap stocks to start catching up to larger stocks during the fourth quarter (in anticipation of the January Effect). Chart 2 shows the S&P 600 Small Cap Index ($SML) ending the week above its 200-day average. The SML/SPX relative strength ratio (top of chart) shows small caps gaining on large caps this week. [The SML gained 2.7% for the week versus 0.9% for the SPX]. Small caps may also be gaining support this week from the surge in the U.S. Dollar Index to the highest level in seven months. A strong dollar has a negative impact on future earnings of large cap multinational stocks. Small caps, however, focus more on the domestic U.S. economy and are less impacted by a strong dollar. That favors some rotating back into smaller stocks. The good news is that should also broaden out the stock market rally and make it even stronger. [More on the strong dollar shortly].
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Chart 2
TREASURY YIELDS SURGE ON STRONG JOBS REPORT... Friday's report that employers added 271,000 jobs in October (with the unemployment rate dropping to 5%) was much stronger than expected. As a result, bond yields surged while bond prices tumbled. That's because the strong jobs report greatly increased chances for a December rate hike. The top line in Chart 3 shows the 2-Year T-Note yield surging to the highest level in five years. That shorter maturity is most sensitive to a Fed rate hike. The lower line shows the 10-Year T-Note yield jumping to the highest level since July. Rising bond yields are good for banks, brokers, and insurers which charge more for their loans (mainly banks) or earn higher income in their fixed income portfolios (brokers and insurers). That explains why those three groups jumped so much on Friday. [The fact that the longer maturity jumped more than the shorter maturity widened the yield curve which helps banks even more].
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Chart 3
RISING RATES BOOST BANKERS, BROKERS, AND INSURERS... Banks benefit from rising rates in two ways. Rising bond yields allow them to to charge more for their loans. A steeper yield curve (when longer rates are rising faster than shorter rates) increases their net interest margin. In other words, they can pay less to bank depositors than they're charging for loans. Although all banks jumped on Friday, smaller regional banks did a little better. Chart 4 shows the KBW Regional Banking Index (KRE) gapping up to a new high. Its relative strength ratio (above chart) did the same. I suspect regional banks did a little better than large money center banks because of their focus on the domestic U.S. economy, with less foreign exposure. Chart 5 shows the Dow Jones Life insurance Index surging as well. Most of the income generated by insurers is invested in fixed income instruments. Higher yields mean higher income potential. The same is true of brokers. Chart 6 shows Dow Jones Brokers/Dealer Index rallying as well. All three financial groups are above their 200-day moving average lines with rising relative strength ratios.
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Chart 4
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Chart 5
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Chart 6
RISING YIELDS HURT REITS AND UTILITIES... As has been happening since the prior week when rates started rising, investors have been selling dividend-paying REITs and utilities. Utilities are also considered to be bond proxies that rise and fall with bond prices. Chart 7 shows the Utilities Sector SPDR (XLU) plunging more than 3% below its moving average lines. Its relative strength ratio (above chart) plunged as well. REITs were sold for the same reason. Dividend-paying stocks lose favor when bond yields are rising. Chart 8 shows the Dow Jones REIT Fund plunging on Friday as well. Dividend-paying consumer staples were also sold on Friday.
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Chart 7
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Chart 8
CONSUMER CYLCLICALS/STAPLES RATIO HITS A NEW HIGH ... Consumer staples also sold off on Friday, but not as much as REITS and utilities. I explained last weekend that, in a rising rate climate, dividend-paying staples usually underperform economically-sensitive cyclical stocks. That's especially true if rates are rising on stronger economic news. The black line in Chart 9 shows the Consumer Discretionary SPDR/ Staples ratio breaking out to a new high. [Cyclicals gained on the week while staples fell]. That also usually happens when bond yields are rising. The green line in Chart 9 represents the 10-Year yield, and shows that rising bond yields usually result in a rising cyclicals/staples ratio. That's also a vote of confidence in the economy and stock market.
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Chart 9
DOLLAR INDEX SURGES TO SEVEN-MONTH HIGH ... Another big side-effect of rising Treasury yields (and increased prospects for a Fed rate hike) is a surging dollar. Chart 10 shows the U.S. Dollar Index ending the week at the highest level since April. It rose against all major foreign currencies, as well as emerging market currencies. There are a number of intermarket side-effects to a stronger dollar. As already explained, it favors small cap stocks. It's also negative for commodity prices (especially gold) and stocks tied to them. It puts downside pressure on foreign stocks tied to commodity prices. It also works against emerging market currencies and stocks like Brazil, Mexico, South Africa, and Russia -- all of which sold off this week. A rising dollar also increases the need to to used currency-hedged foreign stock ETFs.
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Chart 10
CURRENCY HEDGED FOREIGN STOCK ETFS ARE LEADING ... A rising dollar also hurts ETFs of foreign developed stocks. That's because ETFs are quoted in dollars and underperform when local currencies weaken. That's especially true in Europe and Japan. A weak Euro and yen actually help those countries by boosting their exports. The explains why German and Japanese stocks jumped this week. But their ETFs quoted in dollars weakened. That's why it's necessary to use a foreign stock ETF that hedges out the negative impact of falling currencies. Chart 11 shows the WisdomTree Europe Hedged Equity ETF (HEDJ) gaining ground on the week and closing just above its 200-day average. Chart 12 shows the WisdomTree Japan Hedged Equity ETF (DXJ) doing pretty much the same. The rising dollar increases the need for foreign currency-hedged ETFs.
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Chart 11
