Tuesday, October 8, 2013

Making a difference: market cap size and interest rate direction

Amidst much talk and reporting of a possible U.S. debt default, the stock market continues to take it all in relative stride. That's not surprising since the market did quite well during the last government shutdown, with investors presumably assuming this time around that once again Congress will eventually hammer out an agreement. I'd like to assume the same, that we'll avert default and thus disaster, and I never want to say it's different this time because usually it's not, but considering the extreme degree of dysfunction in Washington perhaps this time it really is different.

It's interesting to view the stock market by market cap as different pictures are taking shape.

The weekly charts above show the DJ Industrials, S&P 500 and Russell 2000 Index, respectively. In general, the lower the market cap, the more bullish the chart. In fact, the DJ Industrials is in the midst of carving out a bearish head-and-shoulders pattern. The S&P 500 remains in a solid uptrend, recently pulling back to its 50-day moving average, and the Russell 2000 looks terrific as it just hit a new high and remains well above its 50-day MA. All in all, a bullish backdrop for the market as the flatter small-cap index with nearly 2000 stocks is more indicative of healthy breadth and internals than the more top-heavy S&P 500, not to mention the mega-cap and sparsely populated DJ Industrials.

I would also emphasize that even though the DJ Industrials appears to be taking on dandruff, as I always remind, it's important not to jump the gun and overly anticipate what may happen with a formation-in-progress. For a head-and-shoulders pattern to actually become bearish, the neckline must be penetrated to the downside -- something that has yet to occur (neckline at about 14750 level) and, importantly, may not occur at all.

Taking a closer look at the S&P 500, the daily chart remains fairly bullish.

As already mentioned, the Index remains in an uptrend, well within the ascending channel that has been in place since the start of summer. 1675-1680 looks to be an approximate level of support from the prior high in May and also with the 50-day MA currently residing at 1679. The stochastic is just below 20 indicating the Index is oversold within the uptrend; note in the past such conditions have been opportunistic entry points (green circles). It's prudent to wait for the stochastic to hook-up and rise beyond 20 to better confirm a buy signal. I would also point out that the MACD is trending lower as the S&P 500 has headed higher, a negative divergence that certainly warrants close monitoring.

Finally, with regards to interest rates, I thought the following chart of the S&P 500 and 10-year UST yield was revealing.

Over the last several years, interest rates have generally trended down, primarily due to the Fed and QE activity, and in that time the stock market has generally risen, primarily due to the added liquidity in the system. However, notice in the chart above that within these longer-term opposing trends (interest rates down, stock market up), the S&P 500 (market) and 10-year UST yield have tended to have a positive relationship. The lower inset shows the rolling 200-day correlation for the S&P 500 and UST 10-year yield and clearly the two have been positively correlated. What this means is that while the longer-term trends have generally been diverging, in the more intermediate- to short-term time frame stocks and interest rates have tended to move in tandem. In other words, the near-term directional move of interest rates has tended to correlate with the near-term directional move of stocks -- with the longer-term trends of each gradually deviating over time.

Why would rising interest rates be "good" for stocks, and vice versa? Three related reasons come to mind: 1) rising yields = falling bonds, inferring capital is being reallocated from bonds into stocks, 2) rising interest rates infer a stronger economy and less need for Fed assistance via QE, with a healthy economy being bullish for stocks, and 3) capital very often flows into US T-bonds for safety reasons, driving down rates or yields, and because such capital flow indicates risk-off, it's bearish for equities.

The chart above shows what looks to be an inverse head-and-shoulders formation for the UST 10-year yield, with the yield piercing through the neckline at about 2%. During this time, the S&P 500 has more or less appreciated with the rise in rates, and has likewise stalled out more recently with yields as the 10-year rate has pulled back from near 3% to about 2.6%. I believe UST yields have been falling of late due to reason #3 discussed above, as investors have been flocking to the safety of US bonds given the looming threat of debt default (I know, doesn't quite make sense, but I get it). The growing fear that perhaps it truly is different this time has kept both equities and UST yields under pressure.

In sum, and assuming this time is not different, for now the market outlook remains relatively good.
(Source for all charts: Stockcharts.com)

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