Confidence Is Eroding Just When It's Needed

• Indexes on the Brink
• Confidence Relationships Starting to Break Down
• Watch the Stock/Bond Ratio

Indexes on the Brink

More than once a week, I make sure to check several ratios that tell me whether investors and traders are getting more or less confident. These relationships, which we will get to later, tell us what market participants are actually doing with their money, as opposed to what they say they are doing or thinking. As you might guess from the title of this article, things are not looking very good in the confidence department right now.

Chart 1 tells us why this is important. Some indexes have already completed 1-year tops; several others are poised to do likewise. Declining confidence could therefore be the tipping force for lower prices. The top window shows that the S&P, though below its 200-day MA, is still trading comfortably above a potential head and shoulders neckline. The NASDAQ Composite ended Monday’s trading right at its line, while the NYA broke down from its top some time ago. Finally, Monday saw the Dow Jones E-Commerce Index ever-so-marginally penetrate its line. To say that these indexes, taken in total, are on the brink, would be no exaggeration.

Chart 1

Confidence Relationships Starting to Break Down

Bond spreads, where a low-quality credit rating is compared to a high quality one, are a useful relationship to monitor. That’s because swings in these ratios are determined by bond market investors and are totally independently of equity market folks. One of my favorite relationships is to compare the iBoxx High Yield ETF (HYG) to the Barclays 7-10-year Treasury ETF (IEF). When the ratio is rising, it means that investors are bidding up the price of junk bonds relative to treasuries, as they have relatively little fear of potential defaults. A falling ratio signifies the exact opposite.

There are two ways to plot this relationship in StockCharts. First, we can simply compare the symbols, as in Chart 2. StockCharts includes dividend and interest payments in its closing prices. As you can see from Chart 2, the ratio has been in an uptrend for quite a while, having been supported by the higher payments offered by junk bonds. However, it has started to break down in the last couple of sessions.

Chart 2

I prefer to ignore these interest payments by plotting a simple price comparison between the two ETFs. To do this, just add an underscore in front of the symbol, as in Chart 3. As you can see, the upward bias derived from the high yield payments are eliminated, returning a series that traces out a horizontal trading range. It, too, has broken to the downside. In this instance, though, the size of the trading range tells us that something important has happened here, as we have now embarked on a downward trend in confidence.

Chart 3

This same impression is offered from the relationship between the Fidelity Capital and Income Fund and the Vanguard Long-Term Treasury, which reflects another high-yield/low-risk relationship. Once again, a two-year trading range has been broken on the downside. The nature of this break suggests that confidence has only just begun to erode. That does not mean that stocks will suffer immediately, as often there is a lag between the ratio and the S&P. Nevertheless, coming at a time when the indexes are so delicately positioned, this does not make for the best of timing.

Chart 4

The same deterioration in confidence appears to be happening on a global basis. Chart 4, for instance, compares the price of the iShares International High Yield ETF with that of the Barclays International Treasury (_HYXU/_BWX).  This series has also broken to the downside in the last couple of sessions. Since our limited history suggests that there is a close connection with the Dow Jones World Equity Index, that break is not a good sign.

Chart 5

Growth/value is a popular relationship and is featured in Chart 6. A rising ratio, favoring the more risky growth stocks, does not necessarily translate into a higher S&P Composite and vice versa. However, given the precarious nature of the growth-oriented Dow Jones E-Commerce Index, as seen in Chart 1, this week’s sharp drop in the ratio is not a good sign.

Chart 6

Chart 7 compares an ETF following high beta stocks included in the S&P 500 to a similar ETF that follows its high quality counterparts. Once again, a rising ratio indicates growing confidence and vice versa. During the 2015-16 decline, this series consistently led the S&P itself in a downward trajectory. In 2017, a declining ratio completely failed to signal equity market weakness. That is why this relationship should not be used blindly but in conjunction with others. This series is now providing another warning, having peaked out last summer and experienced a nasty decline since then.

Chart 7

Chart 8 pits the more speculative technology with a defensive consumer staples ETF (XLK/XLP). It recently cracked a 3-year uptrend line and experienced a long-term KST signal. That’s not a good sign either, because it implies that these investors are likely to remain cautious in their preference for the relative safety of consumer staples.

Chart 8

Watch the Stock/Bond Ratio

Finally, market participants have recently been concerned that rising rates may adversely affect equity prices. It looks as though they may be right, because Chart 9 shows that the ratio between the _SPX and _TLT has already violated a 2016-18 uptrend line for both it and the Special K. The series of rising peaks and troughs is still intact, but a daily close under 22.5 would strongly suggest that rising rates had begun to adversely affect stocks.

Chart 9

Good luck, good charting and a happy Thanksgiving to our US based readers.
Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group of Walnut Creek or its affiliates.