Monday, April 29, 2013

10-year Yield & Small-caps Not Confirming Recent Market Rally

For the last several weeks, the 10-year T-bond yield has been declining as the stock market (S&P 500) has been rising or working sideways: 

Source: Bloomberg

Over time, T-bond yields tend to be positively correlated with the stock market:

Source: Bloomberg

In general, as the stock market rises, so too does the 10-year yield, and vice versa. There are a few good reasons for why this correlation should hold, one being rising T-bond yields infer the economy is strengthening. Typically low government bond yields are due in large part to the Fed keeping rates low for the benefit of an anemic or ailing economy. Signs of economic growth are going to make it less necessary for the Fed to maintain such low rates, in effect framing rising yields as a bullish indication for equities. Another reason rising yields are bullish for the stock market is very simple: it implies money is getting re-allocated out of bonds (yields rise) and most likely into equities. 

And yet as you can see in the first chart above, the 10-year yield is not confirming this recent rally in the stock market, a potential red-flag.

Also note that small-cap stocks likewise have not been confirming this recent S&P 500 move:

Source: Bloomberg

The Russell 2000 Index has been trending lower since mid-March, making lower highs as the S&P 500 made a new high and is trending higher. It doesn't always hold true, but more often than not one wants to see smaller-cap stocks confirm the move of larger-caps. An index like the S&P 500 is very top-heavy, reflecting the ups and downs of several mega-caps, whereas the Russell 2000 Index is a much flatter and more equal-weighted benchmark, offering a better representation of market breadth. Based on the chart above, the average stock is not doing as well as the S&P 500 would suggest -- another potential red-flag.

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