By Pater Tenebrarum at Acting Man blog
The divergence between US and European stock markets which we discussed in late August continues to persist. This happens in spite of the fact that major European markets have been somewhat stronger than US markets in recent weeks, no doubt due to further easing by the ECB – which was first anticipated, and then became reality. In fact, the measures announced by the ECB “exceeded expectations”.
Below is an updated version of the chart we showed previously. Germany’s DAX and France’s CAC-40 have rallied back to their previously broken trendlines and appear to be turning down from there. If they fail to exceed the recent interim peaks, their divergence with the SPX will so to speak have been “perfected”. Note though that we have seen similar short term divergences between these markets before (it happened e.g. in the summer of 2013), so it remains to be seen if they are meaningful this time.
Even though one cannot be certain yet whether it is an important signal, it is something we are keeping an eye on, especially as all these markets are far more stretched to the upside than they were previously. We have picked the DAX and CAC-40 on purpose, because they are the stock markets of the euro zone’s “core” countries. Moreover, the DAX has been Europe’s strongest market, the only one that has managed to reach new all time highs since the 2008 crisis. To be sure, the divergence is relatively small at this juncture, due to the recent strength in European stocks. Obviously though, no-one is going to ring a bell and shout “this time it means something”, even if it later turns out that it did. So it probably pays to be aware of these things in good time. If the divergences are going to be invalidated, it is in any case likely to happen soon, as it would require only very little by way of an additional advance. Another reason why these divergences may actually be more meaningful this time around is that a very similar divergence between SPX and HYG (an ETF serving as a proxy for high yield debt) has recently formed. DAX, CAC-40 and SPX – the former are still diverging from the latter and may just have put in a lower high right at their previous trendline support – click to enlarge. Similar to the divergence above, the one between SPX and HYG is also fairly small as of yet and may still be eradicated, but for the moment it clearly exists. After performing roughly in line with the stock market from 2009 to 2013, HYG has actually begun to weaken relative to the SPX since Q2 2013, a trend that has so far continued in 2014. HYG and SPX also diverge at the most recent peak in US stocks – click to enlarge. As the next chart shows, from 2009-2013, HYG and SPX rallied at roughly the same pace. This behavior has changed since Q2 2013, with the S&P 500 outperforming HYG in terms of capital gains. This shows that the decline in yields has slowed down considerably (in fact, since Bernanke’s “tapering speech”, junk bond yields have oscillated at very low levels in a side-ways channel). Note that due to the convexity effect, prices of long term bonds rise much more if yields decline from e.g. 4% to 3% than they do on a similar 100 basis points decline from e.g. 10% to 9%. As declines in yields slow down with yields reaching lower levels, there are in short still very large capital gains possible (e.g. the decline in 10-year German Bund yields over the past two years from a high of about 3.5% to a low of about 0.9% produced approximately a 25% capital gain). Relative performance of HYG vs. SPX – since Q2 2013, HYG has begun to underperform – click to enlarge.
The above divergences are yet another subtle warning sign. Whether they warn merely of a correction or something worse of course remains to be seen. However, the issuance of high yield corporate debt since 2009 has broken one record after another, so we continue to suspect that this market segment represents a major Achilles heel of the entire universe of “risk assets”. Euro area stock markets have shown strong relative performance for a little while, seemingly ending their long streak of underperforming US stocks, but this has been put in doubt again by the recent action (especially when looking at a geographically more diversified cap weighted index such as the EuroStoxx Index vs. the SPX). Needless to say, in terms of aggregate economic data, most European economies have also underperformed the US economy and have recently resumed their relative weakness as well.