I hope you had a great week. On the face of it, markets appear to be relatively calm with the S&P 500 holding firm around the 3000 level and the VIX at a 13 handle (having nearly touched 25 only last month). But beneath the surface, things are seemingly more chaotic. Although there has been momentary relief in the typical ebb and flow of news this week, the critical issues concerning the US - China trade negotiations, Brexit and weakening global economy remain unresolved. However, it is said that markets trade ‘at the margin’, meaning that they adapt as new information is available. So for the past week or so, it seems as though investors are viewing things with slightly less pessimism than before, which has supported a bounce in oversold risk markets as we commented on in this week’s Trading Club video.
Here you can see our market risk Checklist which identifies whether investors are likely to have a preference for riskier or safer asset classes. With a +2 this month, there was clear potential for a 'return to risk'.
Looking at the ratio of the Industrials to Consumer Staples sector ETF ratio, the 'risker’ cyclical sector (XLI) has outperformed the ‘safer’ defensive sector (XLP) as the line on this chart has risen, as correctly anticipated by our Checklist. In fact, the gauge has risen 7% off the low of 1.22 at the beginning of the month.
Continuing this theme, we also saw positive confirmation in our other Checklist for US equities. With a similar score of +2, our process identified a potential long setup despite the overwhelming investor pessimism (admittedly, myself included!).
Those who bought equities this month as our Checklist confirmed have enjoyed a really nice rally in the S&P 500 from just below 2900 to 3000 now - within a hair of a new all time high.
But frankly, it doesn’t appear warranted. The oldest rule in this game is that “the market is always right”, but I have also heard that “the bond market it never wrong.” So when I see the business cycle Checklist receding to 0, and poised to flip negative next month, I look to the latter to validate whether the equity market is ‘right’ approaching a new record high.
Here’s the chart that adds courage in my conviction that this recovery in equities may prove to be short lived, and is not to be trusted. 10-year US Treasury bond yields touched 1.5% a couple of weeks ago as the ISM missed and fell below 50 (as I correctly forecasted) and the yield curve inverted. Yields were heavily oversold (bonds overbought) and saw a very sharp retracement which failed at the 23.6% fibonacci retracement level. Technical analysts would say that this suggests that the current leg lower (‘wave’) is not yet over and looks set to continue. I’m not sure whether that will prove to be the case, but I know that it would be an ominous sign for the global economy if it does.
Whilst I haven’t bought bonds here, I would be keen to do so if we can first get a deeper retracement between the 38.2% and 61.8% levels (yield 2.1% and 2.5%, respectively). Time will tell how this all plays out, but what’s clear is that things are becoming far more complicated in markets and it has never been more important to trade with a proven investment process. We provide our Checklists for a range of markets at the Trading Club and update them for our members on a monthly basis with video updates each week tracking the evolution in markets.
If you would like to join us for our full analysis including new insights each week, or learn from the ground up with online tuition from Lex in our MDT online course, then sign up today and take your financial knowledge to the next level right away!
Have a great weekend,
James Helliwell | Chief Investment Strategist