One branch of technical analysis studies the relationships between asset classes to determine the health of the financial markets. John Murphy has written extensively on this subject and I have gathered a lot of my own wisdom through his teaching. With that in mind, here are a few relationships that I am watching right now to help determine the health of the U.S. stock market.
The chart to the right looks at the consumer staples sector versus the consumer discretionary sector (in the top panel). As the line falls it means that consumer discretionary stocks are outperforming staple stocks. I like using this ratio to measure stock market risk because of the size of the consumer as a percentage of GDP. The line has been, for the most part, trending down since the beginning of 2013 (and really since the 2009 bottom) as economic improvement is reflected in the stock market. However, recently I see a trend break as the line moved above the red downtrend. This signals to me that investors are getting nervous about consumer spending. (Additionally, if you’re familiar with more detailed technical analysis, the trend break was accompanied by a bullish divergence in momentum, adding validity to the break.)
The second chart compares Junk bonds with Investment Grade bonds (using JNK and LQD as proxies). When the line is rising, it means that junk bonds are outperforming investment grade bonds, and this is a good way to measure risk in the bond market. The chart also shows the S&P 500, which is the yellow line. Look at the relationship between the two lines since September 2013: The Junk to Investment Grade line (as marked by the solid horizontal white line) was basically flat, which suggests that bond market participants were not increasing their risk since September. The S&P 500, on the other hand, continued to rise, as indicated by the up-sloping red line. This is a warning sign coming from the bond markets.
While this barely scratches the surface on intermarket technical analysis, if we combine the message from the two charts, we get a rudimentary picture of the health of the markets right now. Stock market participants are moving out of discretionary names and into staple names on the consumer side while bond market participants are choosing investment grade bonds over junk bonds. This is clear risk aversion in both markets and it indicates that the health of the markets is fragile.
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