A tale of two markets

Mid-week market update: When we last left the stock market on the weekend, the bulls were given a homework assignment (see A failed Santa rally, what now?).

 

  1. The S&P 500 and Russell 2000 had to stage upside breakout through the falling dotted trend line. While the S&P 500 briefly broke out, it retreated yesterday through the trend line. The Russell 2000 never came close to a breakout.
  2. The S&P 500 and Russell 2000 had to break out of their sideways range. Not yet.
  3. Small caps should outperform, indicating broadening breadth and better participation in an advance. The bad news is the small cap Russell 2000 is lagging. The good news is the equal-weighted S&P 500 is holding up well on a relative basis, and small caps outperformed yesterday during the market decline.

 

 

Tuesday’s equity pullback was attributable to the rise of the bond market vigilantes, who pushed bond yields up and rattled overall risk appetite. On the other hand, the stock market’s own technical internals are supportive of an advance.

 

In other words, it’s a tale of two markets.

 

 

The return of the vigilantes

The bond market vigilantes are back. The extremely sensitive inflation factor trade of going long the bond market’s inflation expectations ETF (RINF) and short the long-dated Treasury bond (ZROZ) shows that inflation expectations are breaking out.

 

 

Unsurprisingly, the term premium, which measures what the market demands for extending time to maturity, has risen to the highest level seen in a decade.

 

 

The rise of the bond market vigilantes were not just restricted to the U.S. John Authers documented how yields were rising in Europe as well.

 

 

A puzzling reaction

Rising bond yields were puzzling inasmuch as November JOLTS signaled a weak labour market. While job openings were higher than market expectations, job openings represent a noisy indicator of labour market tightness because companies often advertise non-existent jobs to fill their resume banks. The more important quits to layoffs ratio, which has led nonfarm payroll employment, weakened. Investors should get a better read on the jobs market when the December Payroll report is released Friday.

 

 

The weaker than expected JOLTS internals should have seen bond yields
fall and bond prices rise. Instead, yields rose as inflation
expectations surged. From a technical perspective, the 7-10 year Treasury ETF IEF, which represents the belly of the yield curve, experienced a positive RSI divergence.

 

 

The RSI divergence is less obvious in the long end of the curve, as represented by TLT.

 

 

These technical conditions should be supportive of a bullish outcome for risk appetite.

 

 

Constructive equity technical conditions

Over in the equity market, technical conditions are also supportive of the bull case. I am seeing similar patterns of positive RSI divergences in equity indices, which should limit downside risk.

 

 

Breadth is negative but gradually improving even as the S&P 500 tests a key support level. I interpret this as a constructive positive divergence.

 

 

One worrisome development can be found in option sentiment. The put/call ratio has been remarkably low during the latest market decline, which is a signal of complacency.

 

 

My inner trader is giving the bull case the benefit of the doubt, but he could re-evaluate his position if the market were to break short-term support in the coming days. The usual disclaimers apply to my trading positions.

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

 

 

Disclosure: Long SPXL