Don’t Chase This Rally; Weak Outlook for Stocks
As stocks roar back from Brexit lows, bonds, defensive sectors and gold are leading the charge higher.
By Michael Kahn
After two days of free fall, the stock market has now spent three days rallying back, and the Standard & Poor’s 500 retraced about three quarters of what it lost. Fear as measured by the CBOE Volatility Index, a.k.a. VIX, is already significantly below where we were before the Brexit vote.
On the surface, it seems that the panic was indeed overblown, as I wrote here Tuesday. However, I also thought the market was still weak, and there is now more technical evidence to support that view.
It is borne out of two key observations. The first comes from the bond market as interest rates remain at very low levels. Rates fell Friday and Monday as stocks plunged, but they did not move higher as stocks recovered. This suggests that the bond market still believes that something is still wrong in the economy.
Further, the yield curve flattened a bit more. The spread between the yields on the 10-year Treasury note and the two-year Treasury note remains quite narrow. That hurts bank stocks directly but also keeps the narrowing trend intact. A flat yield curve is often a precursor to a recession.
The second observation comes directly from the stock market. Sectors that outperform in times of uncertainty or trouble are indeed leading. As the chart of the relative performance of several Select Sector SPDR exchange-traded funds shows, two traditionally defensive groups — Consumer Staples and Healthcare — have recovered all that they lost after the Brexit vote (see Chart 1).
And the two sectors that are worse off relative to the market since that time are Basic Materials and Financial.
This chart overlays the performance of various sector ETFs with the S&P 500 and lines them up with the close last Thursday before the Brexit vote. It shows us very clearly which sectors are mostly unscathed and which are damaged in its aftermath.
The other sectors, such as Consumer Discretionary and EnergyLE in Your Value Your Change Short position , sport performances on par with the S&P 500, so they were omitted from the chart for clarity.
I interpret this chart to mean that the market, despite a bear-busting recovery rally, is still looking for trouble ahead.
In the next chart, the Utilities and the VanEck Vectors Gold Miners ETF are added (see Chart 2). As we’d expect, utilities outperform the S&P 500 as they track closer to the bond market.
However, gold stocks blow everything else away. This may not be much of a surprise, but considering that gold mining stocks are components of the basic materials sector it makes the lagging performance of that group even more exaggerated. Remove gold from the sector and the remainder — chemicals, packaging and construction materials — look that much weaker.
Combine the signals from the bond market and the stock market and it makes this week’s recovery look to be just the erasure of last week’s end-of-the-economic-world panic. The overall look for stocks and the economy by extension remains as it was before the vote — weak.
Heading for the hills is not necessary. But preparing for a downturn makes abundant sense.
Michael Kahn, a longtime columnist for Barrons.com, comments on technical analysis at www.twitter.com/mnkahn. A former Chief Technical Analyst for BridgeNews and former director for the Market Technicians Association, Kahn has written three books about technical analysis.