SMALL STOCKS START TO SHOW LEADERSHIP -- DOLLAR NEARS 13-YEAR HIGH AS EURO WEAKENS -- COMMODITY DEFLATION HOLDS BOND YIELDS DOWN -- SO DO NEGATIVE EUROZONE YIELDS
SMALL CAP INDEXES TURN UP -- MIDCAPS ARE RIGHT BEHIND... Smaller stocks are not only catching up to larger stocks, they're starting to do better. That normally happens near yearend in anticipation of the "January Effect" when investors favor smaller stocks. Chart 1 shows the S&P 600 Small Cap Index ending the week at the highest level in three months. It has also cleared its 200-day moving average. The $SML/$SPX relative strength ratio (above chart) has also turned up. Chart 2 shows the Russell 2000 Small Cap Index ($RUT) clearing its November high as well. It's nearing a test of its 200-day line. Its relative strength ratio has also turned up. Midcap stocks are right behind. Chart 3 shows the S&P 400 Mid-Cap Index ($MID) ending just shy of its November high and 200-day line. Its relative strength ratio has bottomed as well. For the holiday-shortened week, the Russell 2000 and S&P 600 Small Cap indexes gained 2.3% and 1.9% respectively, versus a 0.05% gain in the S&P 500 Large Cap Index. Midcaps gained 1.5%. New buying in smaller stocks also served to broaden out the market's uptrend as it enters December which is usually the strongest month of the year. Another factor favoring small caps over large stocks is the rising dollar. That's because a stronger dollar hurts the earnings of large multinational companies that get most of their earnings from foreign markets. Smaller stocks are more closely tied to the U.S. economy.
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Chart 1
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Chart 2
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Chart 3
DOLLAR NEARS NEW HIGH AS EURO WEAKENS... One of the big intermarket stories is continued strength in the U.S. Dollar. The monthly bars in Chart 4 show the U.S. Dollar Index ending the week just shy of a new 12-year high. One of the big reasons for that is the continuing drop in the Euro. The blue monthly bars in Chart 4 show the Euro on the verge of hitting a new 12-year low. Although all other major currencies are falling, the Euro has the biggest influence on the trend of the USD (56%). The main reason for their opposing trends is expectations for the Fed to start raising rates in December, while the ECB is expected to announce more monetary easing, possibly as early as this Thursday. That has a lot of other intermarket influences. For one thing, the strong dollar is keeping downside pressure on commodity prices, and stocks tied to them. Commodity deflation in turn is helping keep global bond yields down, including Treasuries. Negative yields in Europe are also helping to keep Treasury yields down. That helps explain the recent drop in the yield curve.
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Chart 4
YIELD CURVE DROPS TO EIGHT-MONTH LOW... A lot of attention is being placed on the falling yield curve. Chart 5 shows the 10 Year - 2 Year Treasury yield curve falling to the lowest level since March. [The yield curve plots the difference between a longer and a shorter yield maturity]. Normally, the yield curve starts to rise at the start of a Fed tightening cycle as bond yields start to rise. That isn't the case right now. The main reason for the drop in the yield curve is that the 2-year yield (which is more sensitive to a Fed rate hike ) has been rising, while the 10-year yield (which is more sensitive to falling inflation) has been dropping. Historically, the Fed has started raising rates to combat rising inflation. That's obviously not the case now with the CRB Commodity Index trading at the lowest level in 14 years (solid area). It's true that the U.S. economy is starting to do better than most foreign markets which may justify a higher Treasury yield. Monetary easing in Europe and Japan, however, are keeping global yields at historically low levels. That's also keeping Treasury yields down. That's especially true in the eurozone with most bond yields in negative territory.
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Chart 5
LOW GERMAN BOND YIELDS WEIGH ON TREASURY YIELD... Chart 6 shows the unusually wide disparity between the 10-year Treasury yield (2.22%) and the comparable 10-Year German yield (0.462%). The difference between the two yields (176 basis points) is one of the widest in history. [The German 2-year yield is a negative -0.415% versus a Treasury 2-year yield of .922 for a spread of 133 basis points]. Yields in Germany up to seven years are also in negative territory. The same is true of most other eurozone countries. That makes Treasuries a lot more attractive to global investors because of their relatively high yield. When investors buy Treasuries, their yields drop. With the ECB expected to start buying even more bonds shortly, that could widen the spread even further. That's another reason that Treasury yields are dropping, as well as the yield curve. Low inflation, combined with low foreign yields, should serve to keep any rise in Treasury yields in check. That being the case, it's probably a mistake to equate low Treasury yields with a weak U.S. economy. If anything, low bond yields are more reflective of weaker foreign economies.
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Chart 6
HEDGING OUT THE WEAK EURO ... The falling Euro carries good and bad news for investors looking to buy European stocks. The good news is that a weaker Euro boosts the exports of eurozone countries which helps their stock markets. The bad news is that global investors can lose money on the falling Euro. That makes it necessary to choose a trading vehicle that hedges out the negative effect of a weak currency. One such vehicle is the Currency Hedged EMU iShares (HEZU) which is the blue line in Chart 7. The green line is EMU Index iShares (EZU). Notice that the blue line is rising much faster than the green line. That's because the EZU iShares (green line) is priced in U.S. dollars and lags behind when the dollar is rising against the Euro. By contrast, the Currency Hedged iShares (blue line) hedges out the negative impact of a falling Euro. Since the start of the year, the Hedged iShares have gained 14.9% versus only a 2.2% gain for unhedged EZU. That discrepancy between the two EMU ETFs is caused by a -12.4% loss in the Euro. The HEZU/EZU ratio on top of chart 7 shows the much stronger performance by the currency-hedged ETF. That rising ratio also bears a close resemblance to a rising dollar (top line). This same analysis is true of Japanese stocks.
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Chart 7
RISING DOLLAR NOT GOOD FOR EMERGING MARKETS ... Another global effect of a rising dollar is weaker emerging markets. Chart 8 compares Emerging Markets iShares (red bars) to the U.S. Dollar Index (green line) since 2000. It's clear that they usually trend in opposite directions. The strong EEM uptrend between 2002 and 2007 corresponded with a falling dollar. Dollar bottoms during 2008 and 2011 corresponded with EEM peaks. The rising dollar since mid-2014 has pushed the EEM lower. The EEM lost -3.3% this week as the dollar rallied. The reason a rising dollar hurts emerging market stocks is that many of them are tied to commodity prices which fall when the dollar rises. That also explains why this week's biggest EEM losers were Brazil, China, and Russia. Brazil and Russia are big commodity exporters, while China is the world's biggest commodity importer.
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Chart 8
RISING DOLLAR FAVORS U.S. STOCKS ... One huge advantage of a rising dollar is that it favors U.S. over foreign stocks. That's because a stronger currency usually implies stronger economic conditions. Foreign investors also get the benefit of a stronger currency when they invest here. The black line in Chart 9 is a "ratio" of the MSCI World Index (ex USA) divided by the S&P 500 over the last twenty years. The MSWorld Index includes stocks from 22 foreign developed markets. The green matter is the U.S. Dollar Index. The chart shows that a falling dollar from 2002 to 2008 concided with U.S. underperformance (falling back ratio). Since the dollar bottoms in 2008 and 2011, U.S. stocks have done much better than foreign markets (rising ratio). The US/foreign stock ratio rose to a new record this past month as the dollar started rising again (see circles).
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Chart 9
HOME RELATED STOCKS ADVANCE ... Stocks tied to housing helped to lead the economically-sensitive cyclical sector higher this week. Home improvement stocks were the strongest part of the Consumer Discretionary SPDR (XLY). The black bars in Chart 10 show the Dow Jones Home Improvement Retail Index surging to a record high. It was led by new highs in Home Depot (HD) and Lowes (LOW). The third strongest cyclical group were homebuilders. The brown bars on top of Chart 10 show the Dow Jones U.S. Home Construction iShares (ITB) turning up as well. It was led higher by DR Horton (DHI). Although not shown, the ITB recently found support at its 200-day average. Home improvement stocks usually do better when homebuilders are rising as well. That's a sign of a healthy housing market. It's also a sign of an improving U.S. economy.
