STOCKS LOOK VUNLERABLE TO SHORT-TERM PULLBACK -- DIVERGENCE FROM BOND YIELD MAY BE A WARNING -- LOWER TREASURY YIELD BOOSTS UTILITIES AND REITS -- BUT MAY CAUSE PROFIT-TAKING IN BANKS -- HOME CONSTRUCTION ISHARES TEST 2018 PEAK
SHORT-TERM STOCK VIEW LOOKS OVER-EXTENDED...Despite geopolitical concerns at the start of the week between the U.S. and Iran, stocks ended the week higher. All three major stock indexes also hit new records before experiencing some minor-profit-taking on Friday. All trends remain solidly higher here and around the world. With emerging markets continuing to show new leadership. As I see it, the main concern at this point is simply that things may have gotten too good too fast. In other words, stocks look somewhat stretched at this point.
LOSS OF SHORT-TERM MOMENTUM...The daily bars in Chart 1 show the S&P 500 pulling back on Friday after setting a new record earlier in the day. There's nothing ominous there. However, the SPX may be in need of some type of breather; either in the form of a short-term pullback or some consolidation. One of my concerns is signs of weakness in its 14-day RSI line. The circled area in the upper box shows the RSI trading in overbought territory over 70 near the end of December. That was its highest overbought reading since the start of 2018. While the SPX hit a new record this month, however, notice that the RSI didn't. That short-term negative divergence is highlighted by the declining red trendline. In itself, not terribly important. But maybe enough to signal some short-term profit-taking in store. If that were to occur, initial underlying support is likely at its green 20-day average or its recent low near 3214. There's nothing on the chart to suggest the market's uptrend is in danger. But maybe a little too stretched on the upside. There's another intermarket divergence that may also be hinting at some short-term selling in stocks.
TREASURY BOND YIELD DIVERGES...Another short-term concern may be coming from the recent divergence between Treasury yields and stocks.Bond yields fell throughout 2019, and didn't have too much of an impact on the rising stock market. Each sharp downleg in yields, however, resulted in a short-term pullback in stock prices. After trending closely together over the last six months, however, the two markets are diverging again.
COMPARISON OF TNX AND S&P 500... Chart 2 shows the close correlation between the 10-Year Treasury yield (green bars) and the S&P 500 (black bars) during the second half of 2019. They fell together in early August before bottoming together at the end of that month. They dropped again together during September, before turning up together during October. That was when trade tensions between the U.S. and China started to thaw; and investors started buying stocks and selling bonds. And that positive trend continued into November. The red trendline, however, shows the Treasury yield failing to hit another high since then; while stock prices have continued climbing. That divergence suggests that bond investors are not as optimistic as stock investors. And may be signalling a pause in the market's uptrend. Weaker bond yields, however, may be impacting short-term trends in some market sectors.
LOWER BOND YIELDS BOOST UTILITIES...We're talking here about relatively minor shifts between rate-sensitive market sectors. First the good news. Chart 3 shows the Utilities Sector SPDR (XLU) trading close to its record high established back in the autumn. The two top boxes compare the XLU/SPX relative strength ratio to the 10-Year Treasury yield; and shows them trending in opposite directions over the last six months. Lower yields boosted dividend-paying stocks during the summer. A higher yield since early October pushed bond proxies like utilities lower. The recent pullback in yields, however, is starting to boost utilities again. We see the same trend in real estate stocks. And for the same reasons. Both bond proxies do better when bond yields are weaker.
REITS REBOUND... Chart 4 shows the Real Estate SPDR (XLRE) pulling back after bond yields rose during September and October. The XLRE rose over the last month as the TNX has weakened. The chart also shows the XLRE bouncing off its 200-day average (red line), and climbing back over its blue 50-day line. How much lost ground those two defensive bond proxies can recover will probably depend how much lower bond yields drop. Banks are another story.
LOWER YIELDS COULD WEAKEN BANKS... Banks react opposite to the two bond proxies shown above. That's because banks usually benefit from rising bond yields (which usually lead to a steeper yield curve). That also means that a lower bond yield can be negative for banks stocks. The daily bars in Chart 5 show the KBW Bank Index still in an uptrend but starting to weaken a bit. It appears headed for a test of its 50-day average. It's also weakening on a relative strength basis. The solid line in middle box is a ratio of the BKX divided by the S&P 500; and it has fallen to the lowest level in two months. Notice the close correlation between that ratio and the 10-Year Treasury yield (top box). Which suggests that any further drop in bond yields could cause some profit-taking in bank stocks. Not a top in bank stocks; but possibly a short-term correction. There's one other stock group that could benefit from lower bond yields.
HOME CONSTRUCTION ISHARES TEST PREVIOUS PEAK...Home builders also benefit from lower bond yields, and for an obvious reason. Home mortgage rates are closely tied to the direction of the 10-Year Treasury yield. Lower mortgage rates encourage more home buying. Which increases the demand to build new homes. Chart 6 shows the falling Treasury yield over the past year having a very positive effect on the U.S. Home Construction iShares (ITB). The chart also shows the ITB in the process of testing its previous peak formed near the start of 2018. An upside breakout would be another positive sign for homebuilders. Lower bond yields would be a big help. Home Construction stocks were the past week's top performers in the Consumer Discretionary SPDR (XLY). Their past year's 35% gain also made them the top XLY performers. Lower bond yields and lower mortgage rates had a lot to do with that.
