Three Intermarket Relationships that are Forecasting Higher Stocks and Yields
Changing relationships between differing asset classes and markets do not speak that often. When they do, strong evidence that important changes may be afoot is often provided. One of the characteristics that has caught my attention since the beginning of the year is that, on one side, stocks been reacting adversely to a tightening Fed, exploding commodity prices and powerful unstable geopolitical forces; that's to be expected. However, while that's been going on, several relationships measuring confidence have actually been improving.
Credit spreads represent a great example of this phenomenon. A credit spread compares the price (or yield) of a low quality debt instrument to one of superior quality one. A rising relationship is bullish, because it reflects improving confidence and means investors are not expecting generalized defaults. That's also a vote for the economy, profits and, by extension, equity prices. What has impressed me is that many of these relationships have refused to buckle under the negative forces that been around for the last 90 days.
Chart 1 offers an example in the form of the Fidelity Capital and Income to the Vanguard Long-term Treasury Fund (FAGIX/VUSTX). It is essentially a high-yield/ treasury spread. Most of the time, this relationship moves in a similar direction to the S&P Composite, but it occasionally experiences a positive or negative divergence. When such divergences are confirmed by a trend break in the Index, such action is typically followed by a trend reversal.
We see a couple of negative setups labeled "1" and "2". Both were followed by a decline in the S&P. What is surprising is that the 2022 sell-off was not accompanied by a rush to quality, but was a period in which confidence, as reflected in this relationship, actually improved. The ratio bottomed last December and has been zig-zagging upwards ever since, thereby offering a positive divergence and cancelling out the negative vibes from "2". In the last couple of weeks, it has actually managed to break above its 2021-22 resistance trendline; this has been accompanied by a small upside break by the Index itself.
This is important because Chart 2 indicates that the ratio recently broke out from a multi-decade accumulation formation. The latest rally is acting as a re-confirmation of that original move. The green-shaded areas, using the benefit of hindsight, show periods when the Fidelity/Vanguard relationship was been in a rising mode. This has usually been a positive environment for stocks in their own right. It is also apparent that stocks are at their most vulnerable when the ratio's trend is negative.
Chart 3 features another credit spread. This one compares the iBoxx High Yield and iShares 20+ year Treasury Bond ETF (HYG/TLT), adjusted to exclude dividends and interest payments. It is also in the process of breaking to the upside following a positive divergence with the Index. Note that the Special K, which you can read about here, is also doing its best to break out.
That possibility takes on greater significance when we trace the history of this relationship back to the financial crisis. The center window tells us that the ratio has been in a clearly defined down trend since 2007 and, along with its Special K, is slowly edging above its secular down trendline. The green-shaded areas once again flag rising trends in the ratio. Aa declining ratio is certainly not always bearish for stocks. However, apart from the final leg down in the 2007-09 bear market, a rising one invariably is.
My conclusion is that these confidence relationships, along with many short-term oversold indicators, suggest that prices are headed higher over the near-term. That said, many of the longer-term momentum indicators have only just started to go bearish. That strongly suggests that any extension to the current rally is likely to be part of a major trading range, not unlike the 2015-2016 period. Ultimately though, the multi-year confidence breakouts, described above, will likely support another up leg in speculation and confidence, thereby enabling a dangerous extension to the post-2009 secular bull market.
TIP/TLT Breaks for Higher Yields
Improving credit spreads are bullish for the economy because they reflect rising confidence. That also tends to be positive for bond yields. In that respect, Chart 5 adds an additional factor, the ratio between the Inflation Protected ETF (TIP) and nominal bond prices in the form of the iShares 20+ year Treasury Bond ETF. When this relationship is rising, it reflects the fact that bond investors are looking for the inflationary protection offered by the TIP. As a result, swings in the ratio approximate those for the 10-year yield. When it is possible to construct a down trendline for each series and both are violated, higher rates typically follow. We see three previous examples in Chart 5 together with a fourth, which was triggered slightly earlier in the month. Note that the most recent breakout completed a 7-year base in the ratio. It's also supported by a rising long-term KST. That's a pretty big vote in favor of inflation!
Good luck and good charting,
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 Groupof Walnut Creek or its affiliates.
