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Have Bonds Revealed the Stock Market's Next Move?

The SPX has rallied just 5% since the top of the bond market, while TLT has dropped 10%

by 8/16/2012 1:50:21 PM
Stocks quoted in this article:

The last few weeks have been a dead time for equity markets -- the CBOE Market Volatility Index (VIX) is near the annual lows, many indexes are range-bound, and trading volumes are very, very light.

This isn't out of the ordinary for this time of year, but there's a general sense of disinterest among market participants. Sentiment remains bearish-to-cautious/neutral overall, and we've yet to see any sort of panic buying with the S&P 500 Index (SPX) merely 1% off multi-year highs. However, there are signs of what could be a period of bearish capitulation.

Many bears are pointing to small-cap names lagging others, which isn't a good sign for a risk rally. However, the iShares Russell 2000 Index ETF (NYSEARCA:IWM) is currently in a very interesting chart pattern -- the inverse head-and-shoulders. While many beta names have lagged this recent market rally, I believe the stage to be set for some fierce catch-up by these small-cap names. Keep a close eye on this chart pattern.

While observing the indexes and general market sentiment can prove beneficial, the chart I'm most interested in right now is that of the iShares Barclays 20+ Year Treasury Bond Fund (NYSEARCA:TLT). As bond yields have been on the rise lately, TLT is in a period of freefall. Since the highs at the end of July, TLT is down about 10% in three weeks.

Looking at the chart below, there is some hope for bond bulls. The ETF is currently pulling back near the psychological 120 level, its 200-day moving average (yellow), and a significant unfilled gap on a daily chart. While all of these could provide support, a move below this key level could certainly cause panic selling (and contrarily, panic buying in equities). (Click on the charts to enlarge).

Daily Chart of iShares Barclays 20+ Year Treasury Bond Fund (TLT) Since January 2012 with 200-Day Moving Average
Chart courtesy of eSignal

Since bonds and equities typically move in an inverse fashion, a correlation trade would imply that the SPX made a sharp move over this period. The SPX has made some progress since the top in the bond market, but it has rallied by about half of what bonds have retreated (5% equity rally versus a 10% selloff in bonds). This is very interesting because stocks are typically much more volatile than bonds.

Daily Chart of S&P 500 Index (SPX) Since January 2012
Chart courtesy of eSignal

As many market participants continue to attempt to call a top, the indexes keep grinding higher as more and more money flows out of bonds. Given the recent muted performance by equities amid a sharp bond selloff, I would expect some serious panic buying should the SPX break above the yearly highs at the 1,420 level. If this were to occur and general market sentiment shifts bullishly, I would then look to start initiating bearish positions as capitulation buying/covering is often times the top. It is very rare for the market to give you a long time to sell at the actual top, so the sideways action that we've seen the past two weeks is a very bullish signal, in my opinion.

Until then, ride the move higher and keep your eyes open for a day where we see huge buying, and then a late morning or afternoon reversal.

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