DROP IN BOND YIELDS SENDS CAUTION SIGNAL -- THAT KEEPS BANKS ON THE DEFENSIVE -- SMALL CAPS AND TRANSPORTS ARE SHOWING RELATIVE WEAKNESS -- AMAZON RISE OFFSETS DEPARTMENT STORE LOSSES -- TECHNOLOGY SHARES LEAD TAIWAN MARKET TO SEVENTEEN YEAR HIGH
BOND YIELDS DROP ON FRIDAY... Some caution crept into financial markets near the end of the week. Part of that was reflected in Friday's sharp drop in bond yields. Chart 1 shows the 10-Year Treasury Yield falling back below its 50-day average in pretty decisive fashion. That was blamed mostly on Friday's CPI report which came in lower than expected. [I can't help also wondering if the recent slide in commodity prices is dampening inflation expectations]. The red line in Chart 1 shows the 2-Year Treasury Yield suffering its biggest daily drop since March. That reflects some doubt about how aggressive the Fed will be in raising interest rates. The short-term effects of Friday's drop in yields boosted bond prices as well as some other safe havens. Utilities were the day's strongest sector, while financials were one of the weakest. Financials were also one of the week's biggest losers (-1.1%). Banks and insurers were a big reason for that loss.
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Chart 1
BANKS HAVE A BAD WEEK... Chart 2 shows the S&P Bank SPDR (KBE) touching a three-week low early Friday after backing off from a falling 50-day moving average (blue line). The KBE/SPX ratio (top of chart) also lost more ground this week. Chartwise, the KBE needs to clear its April high to improve its chart pattern and its relative performance. It will probably need higher bond yields to do that. The market needs that as well. A weaker dollar may be also hurting small caps.
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Chart 2
SMALL CAPS SHOW RELATIVE WEAKNESS... Another short-term caution signal is coming from a relatively weak showing in small caps. The daily bars in Chart 3 show the Russell 2000 Small Cap Index ($RUT) ending the week right on its 50-day moving average. Of more concern is its falling relative strength line. That's the solid line which plots the $RUT/S&P 500 ratio. That line dropped during the first quarter. After an April rebound, it's falling again. A weaker dollar may have something to do with that. Chart 4 shows a close correlation between the $RUT/SPX relative strength ratio (black line) and the U.S. Dollar Index (green bars). The small cap/large cap ratio spiked with the dollar during November, but has has been falling with it in 2017. There's a reason for that. Small caps usually get the biggest bang for the buck in a stronger economy. That' because they're more closely tied to the domestic economy. Large cap stocks are multinational in nature and depend more heavily on foreign markets. A rising dollar can hurt the foreign earnings of multinational stocks, while a falling dollar gives bigger stocks an edge over smaller stocks. That explains why a weak dollar this year may have something to do with small cap underperformance.
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Chart 3
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Chart 4
TRANSPORTS ARE ALSO WEAKENING ... Back on March 14, I wrote a warning about a weakening in transportation stocks. [Coincidentally, that same message also warned about small cap weakness]. Here we go again. Chart 5 shows the Dow Transports falling to a three week low this week and trading below a falling 50-day average. The stronger solid line plots the Dow Jones Industrial Average. In a strong uptrend, the two lines should be rising together. Right now, they're not. At the very least, I would take that as a short-term warning signal for the Dow Industrials. Here's another one. Chart 6 overlays MACD lines on daily price bars for the Dow. The negative divergence between the Dow and the two lines is disturbing. And they may be close to turning negative for the first time since March. That's also concerning. Maybe bond traders know something stock traders don't.
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Chart 5
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Chart 6
CONSUMER DISCRETIONARY STOCKS ARE STILL HOLDING UP ... Considering the bloodbath seen in department store stocks, it may seem surprising to see the Consumer Discretionary SPDR (XLY) holding up relatively well this week. The XLY lost a relatively modest -0.3% which actually did a little better than the S&P 500. Three of the week's biggest sector losers were Macy's (-18%), Nordstrom (-15%), and Kohls (-9%). [Several stocks in the group, however, saw big gains including Newell Brands (13%), Coach (6%), Marriott (5%), H&R Block (5%), and Wynn Resorts (3%)]. The most important gainer, however, was Amazon (2.9%). That's because it's the biggest stock in the sector. Chart 7 shows Amazon.com (AMZN) gaining 28% this year, versus losses of -33% for Macy's, -25% for Kohls, and -13% for Nordstrom. It would seem on the surface that those big department store losses would outweigh the gain in Amazon. Here's why they aren't. Amazon is the biggest stock in the XLY with a nearly 15% weighting. By contrast, the three department store losers have a combined weight of less than 1%. Department stores represent a very small part of the XLY, while e-commerce retailers hold a much bigger spot. Money isn't leaving the consumer discretionary sector. It's just leaving the malls and moving to the Internet. Consumers haven't stopped shopping. They're just doing it a different way.
Chart 7
WHY APPLE AND TAIWAN ARE LINKED... My Tuesday message explained that technology stocks in Asia were leading emerging markets higher which, in turn, were helping support the technology rally in the states. I used Taiwan Semiconductor (the biggest stock in Taiwan) as an example of that country's close ties to the semiconductor industry here. I didn't go far enough. The Taiwan stock market rose to the highest level in seventeen years this week. An article in the Wall Street Journal this morning points out that half of the gains in the Taiwan Taiex Index over the last year came from three stocks -- Taiwan Semiconductor, Hon Hai Precision Industry (Foxconn), and Largan Precision. They're the three biggest stocks in Taiwan and all three are Apple iPhone suppliers. Chart 8 shows the amazingly close correlation between Apple (red line) and Taiwan iShares (green line) over the last couple of years. Their 120-day Correlation Coefficient is a very high 95%. That's a lot riding on the fortunes of one stock. This is just another example of how dependent foreign markets are on our markets, and why we need them to keep our markets going.
