The Markets Are Holding Onto a Thread

by Serge Berger | July 27, 2012 9:35 am

While the major U.S. indices are solidly in the black for the year, signs all around us indicate it might be in increasingly difficult for these gains to hold. From awful-looking equities in Europe and Asia and inverted yield curves in Spain, to ultra-low bond yields in the U.S. and rising credit spreads, things easily could get tougher going forward.

The world is getting increasingly interconnected, and that holds especially true in the financial markets. Domestic markets can no longer be analyzed in isolation; global trade winds must be a significant factor in the analysis.

And both global trade winds and various asset classes aren’t boding well for the market.

After riding major bull markets in previous years, gold and silver have been consolidating for the past 12 months and recently reached critical support levels. If these current support levels break, next support likely won’t be found for another 5% to 10% lower.

Ever so well-documented is the seemingly never-ending rise in price of U.S. Treasury-issued bills, notes and bonds. The benchmark 10-year Treasury yield keeps making new lows[1], indicating a flight to quality and risk aversion. Who finds these yields attractive enough to invest is an entirely separate discussion, but the mere fact that bond funds still are seeing inflows speaks volumes about investor confidence.

In the world of corporate investment-grade credit: While off highs for the year, the CDX North America Investment Grade Index of credit default swaps has been on the rise since mid-March.

Economic data has steadily worsened on a global basis throughout 2012. Earlier this week, the Richmond Federal Reserve Manufacturing Survey severely disappointed and came in well below estimates.

The lone “star” thus far this year remains U.S. equities — represented by the S&P 500, Dow Jones Industrial Average, Nasdaq 100 and Russell 2000.

Defensive sectors such as utilities, health care and consumer staples have helped to keep U.S. equities afloat. But the very fact that defensive sectors are being bid higher is troubling, as it also indicates investor risk aversion. Cyclical sectors have not seen new highs for 2012 in recent weeks, and thus are decoupling from non-cyclicals/defensives.

The chart below illustrates this well; plotted is the Select Sector Consumer Discretionary SPDR (NYSE:XLY[2]) versus the Select Sector Consumer Staples SPDR (NYSE:XLP[3]). Note the decoupling in May just as broader equity markets came for sale. Despite a rally off June lows, the divergence remains. In other words, cyclical sectors are not confirming the June rally, and thus giving us negative divergence.

Most S&P 500 cyclical sector charts, as well as the S&P 500 itself, currently are displaying what technicians refer to as a “bear flag.” The SPDR S&P 500 ETF (NYSE:SPY[4]) is dangerously close to breaking down and out of the flag, while small caps (often regarded as a leading indicator), as measured by the Russell 2000, already have broken down.

With most major asset classes around the globe flagging warning signals, given global risk asset correlation, it might only be a matter of time until U.S. equities take another dive.

Given the current levels of headline risk, you should work with defined stops and limits more than ever. Remember: You can always re-enter the trade.

Serge Berger is the head trader and investment strategist for The Steady Trader[5]. Sign up for his free weekly newsletter[6].

  1. keeps making new lows:
  2. XLY:
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  4. SPY:
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