Divergences: Stock Market Advance Not Being Confirmed

As I've mentioned here before, I expected the S&P 500 to undergo more of a meaningful correction about 80 points ago -- obviously, I've been incorrect about a correction. 

It's not unusual for me to be early (vs. late) as I do typically err on the side of caution when $$$ are involved, and I prefer to be prudent rather than gutsy. That said I'm always closely tracking the charts/indicators I've grown to value and trust over time as I am vigilant about not committing the behavioral sin of getting overly-attached to an investment stance. Pay heed to your process, stay disciplined, but also remain flexible and always look for reasons why you could be wrong this time. It's a tricky balance (and why this business ain't easy).

After reviewing several such charts and indicators, I do still see some lasting divergences that are concerning, one being small-cap performance versus larger-caps.

 Source: Stockcharts.com

The chart above shows the relative return of the Russell 2000 Index (IWM) versus the S&P 500 (SPY), plotted with the S&P 500 in the background (green line). Note that despite the new all-time highs in the S&P 500, IWM performance has lagged SPY performance with a red line identifying the bearish divergence. I would also point out that the RSI of the IWM:SPY ratio exhibits a bearish divergence, and that the Aroon Oscillator of the ratio remains repressed -- further non-confirming signs of the market's latest advance.

In addition, below I present two more relative return charts, the first showing high-yield (junk) bonds (HYG) versus T-bonds (TLT) and the second chart showing cyclical stocks ($CYC, Morgan Stanley Cyclical Index) versus staples (XLP). Both have the S&P 500 (green line) in the background.

Source: Stockcharts.com

The HYG:TLT ratio has been heading in the right direction (up), however it needs to surpass its prior high set in March to confirm the S&P 500's new highs. Likewise, in the second chart, the $CYC:XLP ratio has been heading in the right direction but it appears to be rolling over at the key 100-day moving average (I've discussed this indicator in the past). Also, note the developing bearish divergence of the $CYC:XLP ratio as it looks to be making a lower high for the third time -- as it did in February-April of last year. 

I will be the first to state that by definition, divergences lag and they can eventually disappear, i.e. finally confirming a move. However, in my experience, as they develop and remain in place one would be wise not to ignore the potential implications. All in all, I continue to be wary of this recent rally in the market.

Copper/Gold Ratio at Inflection Point

I keep track of the copper/gold ratio as it relates to the market.

Source: Stockcharts.com

In many ways, the copper/gold ratio is just another version of a risk-on/risk-off metric. Copper is very sensitive to economic forces, rising in price as global economies expand and demand for copper increases (risk-on). And we know that gold represents a safe-haven asset (risk-off). Therefore whenever the copper/gold ratio is rising, it's generally bullish for the stock market and vice versa, when falling it's generally bearish for the market.

In the weekly chart above, I use the Vortex Indicator (VI) to identify when the copper/gold ratio is in an uptrend or downtrend. It's not perfect (no indicator is, which is why you need to use many), but in isolation the trend of this ratio does a fairly good job at being on the right side of the market.

The current reading is interesting, with the VI seemingly at an inflection point. I typically wait for a more definitive signal to develop from the VI, one where the green and red lines are more clearly deviating from each other. Right now the lines are too close together to conclude much of anything concerning market direction -- stay tuned.

Is It the Dawning of the Age of America?

If you follow the news, you'd think the U.S. remains in quite a bit of trouble. However, with most broad U.S. equity indices hitting new all-time highs, either investors are idiots (possible, but doubtful) or the headlines are not telling the whole story (more likely).

To some extent, one could argue the success of U.S. stocks is due to a relative game of being the "prettier pig." The U.S. may have a number of serious issues needing resolution, but compared to the problems facing the rest of the world, we're doing just fine. 

Source: Stockcharts.com

The chart above shows the S&P 500 vs. MSCI World ex-USA and as you can see, U.S. stocks have been leading the world for years now, not just in the last several months. 

Going one step further, the case can be made that we're just in the early innings of a U.S. rebirth. The chart below shows the S&P 500/gold ratio, along with gold and the US dollar (USD).

Source: Stockcharts.com

The long-term monthly chart shows that this year the S&P 500/gold ratio finally broke through its downtrend, as represented by the 40-month moving average. The last time this happened was in the early 1990s. The RSI has confirmed this move with it rising well above 50. Note also the fairly high correlation between the S&P 500/gold ratio and the USD, with the USD in a gradual uptrend for a few years now, further indicating U.S. relative strength globally. 

A rising S&P 500/gold ratio infers that investors are increasingly less concerned about, well, anything concerning, meaning they are preferring riskier assets (stocks) over a safe-haven asset like gold. Fear is subsiding and optimism is growing. 

So could this be just the beginnings of a U.S.-led secular bull market? Based on the chart above, it peaked in 2000 and has been downhill ever since -- until recently. What we've observed so far is pretty textbook stuff: a rising market in the face of continued uncertainty and doubts. Such an environment is often the norm during the start of bull markets as prices climb the proverbial wall of worry. Typically what then happens is the market transitions into multiple-expansion mode, with prices rising ever higher on less needed earnings. 

Again, all of this would be in accordance with the playbook and is often what happens with a rising S&P 500/gold ratio (multiple expansion occurring). But we'll see, I always say there are no guarantees and nothing repeats the past exactly. 

I would also remind that the observations and charts above are monthly and longer-term. In the near-term, the stock market appears stretched and I've expected it to correct for a few weeks now -- wrong! It's a testament to the underlying demand for equities, however nothing goes up forever. Better to be prudent than gutsy. Stay tuned.

Tesla Continues to Soar

I wrote about Tesla (TSLA) on April 4th, the blog post was entitled, "Tesla: Earnings, Smernings!" At the time, the stock was up 31% YTD and was hitting a new high. It had bullish cup-with-handle and inverse head-and-shoulders formations, a powerful duo. I wrote then, "Tesla is expected to earn a profit in FY2013, so as per usual price is likely discounting the future, moving on expectations as opposed to past history."

Fast-forward to today, with TSLA up almost 20% this morning as the company reported a better-than-expected 1Q. Deliveries and revenues surpassed consensus numbers, but more importantly TSLA reported its first-ever profit, an EPS of $0.12 versus analysts expecting breakeven to a small loss. Needless to say, the huge outstanding short interest is playing a large part in the stock's massive spike today, with a mother-of-all squeezes taking place. Shares have now almost doubled YTD.

Source: Stockcharts.com

Again, TSLA is another example of price leading the eventual news or the eventual reality. Ever since its IPO, Tesla's stock has steadily risen despite reporting red ink during those years. But now it appears that the company will most likely report a fiscal year profit very soon, to the apparent surprise of many.

As is often said, the chart "speaks" and it frequently pays (literally) to try and decipher what it's saying.

The Market Faces Seasonal Headwinds

Over the last few weeks, I know I'm not the first to mention the "Sell in May, Go Away" truism, but figured I'd give my two-cents on the subject anyway.

The following chart shows the S&P 500 for this year compared to its averages over the last 5-, 10- and 30-years:

Source: Bloomberg

As you can see from the averages, in general the stock market does tend to rise from November through April and decline from May through October. And notice so far this year the S&P 500 has performed quite well (red line), to put it lightly.

I would also mention that BofA Merrill Lynch recently published a study on the seasonal tendencies of the market (S&P 500). The study considered average 6-month returns for the S&P 500 going back to 1928. In that time, the average 6-month return was 3.6% with the May-October period returning half that number, just 1.8%. The November-April period returned 5.0%.

All of this said, I emphasize that seasonal tendencies are just that, tendencies. There are never any guarantees or certainties when it comes to investing. However, when such tendencies in the market reoccur frequently and fairly consistently for almost 100 years, perhaps it's something worth keeping in mind. 

Gold Update

Gold has retraced a bit more than 50% of its recent decline.

Source: Bloomberg

Typically we should see a retest of the prior low, with gold price retreating to the 1350-1400 level.

This recent snap-back rally has been fast and furious, with the 8-day rate of change being one of the best in years.

 Source: Bloomberg

However, note that very often such rapid rises are followed by declines (black vertical lines identify a few such past instances). 

Inflation (both actual and expected) has been declining, serving as a headwind for gold and other commodities.

 Source: Bloomberg

It's my belief that the Fed's new inflation target (5yr5yr breakeven rate) is 3%, so this decline year-to-date certainly has not gone unnoticed. And we know the last thing "Helicopter Ben" wants is deflation.

But it's not as if the Fed isn't trying to boost inflation, with QE continuing at a steady clip.

Source: Bloomberg

Is the VIX ready to pop?

Don't look now but the VIX is close to registering a daily TD Sequential 13 bottom, and has already put in a weekly TD Seq 13 bottom:

Source: Bloomberg

Also note the bullish divergence in the MACD.

And yesterday there was big volume in VIX calls, specifically at the May 16 strike with a 40K print at $0.85: