RISING BOND YIELDS MAY BE PULLING MONEY OUT OF TECHNOLOGY INTO CHEAPER PARTS OF THE MARKET -- APPLE, AMAZON, AND GOOGLE LOSE GROUND -- RISING OIL PRICES MAY CONTRIBUTE TO HIGHER BOND YIELDS -- RISING YIELDS ARE BOOSTING SMALL CAPS
APPLE, AMAZON, AND GOOGLE WEIGH ON TECH SECTOR... While the stock market is holding up okay, some rotations are going on beneath the surface. One is the rotation out of large cap tech stocks, former market leaders, into cheaper parts of the market like financials, small caps, and transports. Let's start with the tech stocks. Chart 1 shows Apple (APPL) falling to the lowest level in two months and trading below its 50-day average. Apple lost -5% this week and more than -7% since the start of September. Chart 2 shows Amazon. com (AMZN) trading below its 50-day moving average as well, and more than -9% off its late July peak. Chart 3 shows Alphabet (GOOG) trading -5% below its June/July peaks (and below its 50-day moving average). Those three stocks account for 60% of the so-called FAANG stocks which had been been market leaders. Their falling relative strength lines (top of charts) show their recent underperformance. Part of the recent tech selling is tied to the rebound in bond yields and expectations for another rate hike this year (more on that shortly). That also explains why investors are buying financials and small caps.
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Chart 1
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Chart 2
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Chart 3
RISING BOND YIELDS CAN BE BAD FOR TECHNOLOGY STOCKS... This headline is taken from a message I posted on July 14. I refer you back to that earlier message for a more complete analysis. I'm going to quote a few sentences here to capture its main essence: "One of the lesser known intermarket principles is the inverse link between bond yields and technology stocks' relative performance...Growth stocks like technology...do better in a slower economy which is usually associated with low interest rates. Value stocks (like banks) do better in a stronger economy with rising bond yields...Rising global bond yields could make the going tougher for technology stocks." Chart 4 shows a generally inverse relationship between the 10-Year Treasury yield (green line) to a ratio of the Technology SPDR (XLK) divided by the S&P 500 over the past six months. Notice that the previous uptick in the TNX during June led to profit-taking in techs that month. [The same thing happened last November following the presidential election]. Rising rates this past month may again be contributing to tech selling, especially with a more hawkish sounding Fed. The inflationary impact of rising energy prices may also give the Fed more cover for a December rate hike.
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Chart 4
RISING ENERGY PRICES COULD BOOST INFLATION... Here's another quote from my July 14 message: "Despite low inflation readings, longer range trends continue to favor higher global bond yields...Which is why traders should also be keeping a close eye on inflation trends. Continuing low inflation should act as a restraint on central bankers like the Fed. Any serious uptick in inflation during the second half of the year could change that and cause profit-taking in technology stocks." That brings another intermarket linkage into play. And that is the recent upturn in energy prices. The black bars in Chart 5 show the price of Brent Crude Oil ($BRENT) rising to the highest level since April. Since late June, Brent crude has gained 25% (which qualifies as a bull market). Brent is the international benchmark for crude oil. I'm using Brent here because it may be giving a truer picture than WTIC Light Crude Oil produced here in the states. The gray line shows WTIC lagging behind Brent since August. That resulted from a drop in WTIC during August resulting from Hurricane Harvey when U.S. refineries were temporarily shut down. The upper box in Chart 5 shows a two-year high in the premium of Brent over WTIC ($6). Historically, that big a premium has usually resulted in higher prices for WTIC. [It also increases demand for cheaper WTIC for export to foreign refiners]. To the extent that rising energy prices boost inflation, that could encourage a more hawkish Fed and increase odds for more rate hikes. That wouldn't be good for technology stocks. But may explain why energy and financials have been market's strongest performers this month. And why money coming out of techs is moving into undervalued energy and financial stocks. And small caps.
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Chart 5
SMALL CAPS ALSO BENEFIT FROM RISING RATES... It's generally known that rising bond yields boost financial stocks like banks and insurers. Rising bond yields, however, are also helping boost small cap stocks. Since late August, the Russell 2000 Small Cap Index ($RUT) has gained twice as much as the S&P 500 Large Cap Index (by a margin of 6% to 3%). Russell 2000 iShares (IWM) touched a record high this week. Small caps are also one of the beneficiaries of money rotating out of expensive large cap tech stocks and into cheaper stocks. But there's more to it. Small stocks are benefiting from the rotation into financial stocks (resulting from higher bond yields). Chart 6 shows a close correlation between the 10-Year Treasury Yield (green line) and a ratio of the Russell 2000 to the S&P 500 Index. Notice the tendency for both lines to rise and fall together. A jump in yields after the November election coincided with a big jump in small cap relative performance. Declining bond yields since the start of the year helped produce relative small cap weakness. This month, however, bond yields and small cap performance are rising together. The main reason is the heavy weighting of financials among small caps. The biggest sector weight in the Vanguard Russell 2000 ETF (VTWO) belongs to financials (26%). That's even more true with small cap value stocks.
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Chart 6
RUSSELL 2000 VALUE ISHARES ARE GAINING GROUND ... Small cap "value" stocks have lagged way behind small cap "growth" stocks this year. But that may changing. The top line in Chart 7 shows the Russell 2000 Growth iShares (IWO) forming a pattern of "higher highs and higher lows" since the start of the year. The black bars in the lower box, however, show the Russell 2000 Value iShares (IWN) trading sideways all year (but nearing a possible upside breakout). Both have gained ground since mid-August. During September, however, the small cap value ETF has nearly doubled the small cap growth ETF (3.9% to 2.6%). There again, the reason for their differing performance is their sector weighting. The two biggest sectors in the growth ETF are healthcare (25%) and technology (24%). Financials are a distant 5%. Healthcare and technology have been two of the year's strongest sectors (but have weakened of late). The value ETF, however, has a 30% financial weight (versus a small 9% weight in technology). There are a couple of messages here. One is that small cap stocks are benefiting from the recent rotation into cheaper stocks tied to financials. A second message is that small cap value stocks may provide an even cheaper alternative for bargain hunters.
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Chart 7
FINANCIAL SPDR HITS RECORD HIGH... Rising bond yields are good for financial stocks but bad for bond proxies like utilities. With bond yields jumping this week, it wasn't a surprise for financials to take over the lead as the market's strongest sector, while utilities were the weakest. In my view, financials still remain one of the cheapest parts of the stock market -- both on an absolute and relative basis. And the sector is looking even stronger on both counts. The monthly bars in Chart 8 show the Financial SPDR (XLF) ending the week at 25.43, which is just above its 2007 intra-day peak at 25.11. Since it's a monthly chart, that record won't be official until the end of the month. But odds for the record to stand look pretty good. And the group is still a relative bargain. The XLF/SPX relative strength ratio (gray line) may be on the verge of an eight-year high. But it shows that financial stocks are still a lot cheaper than the rest of the market. [Energy was the week's second strongest sector behind financials. The third strongest was industrials (XLI), which were led into record territory by truckers and defense stocks. Transportation stocks, another group benefiting from the move into cheaper stocks, had a strong week (1.6%). The Dow Transports are nearing a test of their July peak].
