FINANCIALS LEAD MARKET LOWER -- FALLING YIELD CURVE HURTS BANKS -- FALLING YIELDS, HOWEVER, PUSH UTILITIES TO NEW HIGHS -- SMALL CAPS CONTINUE TO UNDERFORM -- U.S. LARGE CAP STRENGTH MAY HAVE MORE TO DO WITH STRONGER FOREIGN MARKETS
FALLING BOND YIELD PUSHES YIELD CURVE LOWER... The divergence between falling Treasury bond yields and rising stock indexes may be starting to take its toll on the stock market. Major stock indexes are in the red today. The biggest selling, however, is coming from small caps and financials. At the same time, money is flowing into defensive sectors like consumer staples and utilities. The green bars in Chart 1 show the 10-Year Treasury Yield falling closer to its April low and its 200-day moving average. Falling bond yields usually show pessimism on prospects for U.S. economic growth and inflation. Weaker inflation measures of late have contributed to falling yields. So have weaker commodity prices. The more telling line in Chart 1 is red line which is the 10 Year - 2 Year yield curve. The yield curve shown here is the difference between the 10-year and 2-Year Treasury yields. After surging during the fourth quarter, the yield curve peaked in December and has since fallen to the lowest level since last October. That's normally bad for financial stocks, and banks in particular. And that's normally a drag on the stock market.
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Chart 1
S&P BANK SPDR FALLS TO NEW 2017 LOW ... Financials are the day's weakest sector, and banks are the weakest financial group. The black bars in Chart 2 show the S&P Bank SPDR (KBE) slipping below its spring lows to the weakest level since last November. It's also bearing down on its (red) 200-day moving average. The black line shows the KBE/SPX ratio falling to the lowest level in six months. Notice the close correlation by the KBE/SPX ratio and the 10 Year - 2 Year yield curve (red line). A falling yield curve is bad for banks because it narrows the net interest margin between loan income (based on long-term yields) and deposit payments (short-term rates). Falling bond yields are also hurting brokers and insurers which are leading financials lower as well.
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Chart 2
FALLING BOND YIELDS ARE BOOSTING UTILITIES... While falling bond yields are bad for financial stocks, they're good for bond proxies like utilities. And, not surprisingly, utilities are the day's strongest sector. Chart 3 shows the Utilities Sector SPDR (XLU) trading at record highs today. The XLU/SPX ratio (top of chart) is trading at the highest level in six months. That's also a sign that investors have been turning more defensive. So is the fact that the Consumer Staples SPDR (XLP) is also hitting a record high. Both dividend-paying groups also attract money when bond yields are falling. They compete with Treasury bonds for yield.
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Chart 3
RUSSELL 2000 ISHARES SLIP BELOW 50-DAY AVERAGE... Another problem facing the stock market is relative weakness in small cap stocks. And today is no exception. The black bars in Chart 4 show the Russell 2000 Small Cap iShares (IWM) slipping back below its 50-day average. At the same time, the IWM/S&P 500 ratio (solid line) has fallen to the lowest level in six months. That's weighing on the rest of the market. Which is another way of saying that the 2017 stock uptrend has been driven mostly by large cap stocks. So far this year, S&P 500 large cap index has gained more than 7%. Midcaps have gained only half as much (3%), while small caps are basically flat. Since small caps are more closely tied to U.S. economy, their relative weakness is sending the same cautious message as falling bond yields (and a weaker dollar).
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Chart 4
STRONGER FOREIGN MARKETS BOOST S&P 500... One of my recent messages suggested that a weak dollar was giving an edge to large cap stocks over small caps. A falling dollar boosts the exports of large U.S. multinationals in the S&P 500. That's why large caps usually do better than small caps when the dollar is dropping, as it is now. Another factor is that stronger foreign currencies boost the revenue of U.S. corporations when foreign profits are converted back into dollars. Here's another reason. Large stocks in the S&P 500 get nearly half of their profits from foreign markets. [Some get more than half]. Which helps explain recent large cap outperformance. A lot of this year's large cap profitability is coming more from foreign markets than the U.S. The red line in Chart 5 shows U.S. large caps outperforming small caps in 2017. The blue line line is a "ratio" of the Vanguard FTSE All World ex-US ETF (VEU) divided by the S&P 500. That ratio shows foreign stock markets (developed and emerging) rising faster than the U.S. this year by a two to one margin (14% versus 7%). Stronger foreign markets are boosting the profits of U.S. multinationals in the S&P 500. And that may be where most of their growth is coming from. That may explain why Treasury yields and small caps (which are more closely tied to the U.S. economy) are dropping or lagging behind.
