Are the markets beginning to change?… what John Jagerson and Wade Hansen are analyzing for the answer… keep an eye on the Fed’s asset purchase plan

 

The Nasdaq is on pace for its worst monthly performance since September 2020.

It’s down almost 4% since April 19, nearly five weeks ago.

Meanwhile, the Dow and the S&P have traded sideways over that period.

 

Are we seeing a bearish change in the markets?

Today, we turn to our technical experts, John Jagerson and Wade Hansen of Strategic Trader, for their thoughts. While they’re not souring on stocks, John and Wade are keeping an eye on an indicator that suggests the potential for headwinds.

What’s that indicator?

Let’s find out, and what it means for your portfolio.

***Clues about market direction from sector rotation

In their newsletter, Strategic Trader, John and Wade combine fundamental and technical analysis, along with historical market data, to trade options whether the market is up, down, or sideways.

As part of this, they track various macroeconomic indicators to give them clues about which way the market is headed.

In John’s and Wade’s Strategic Trader update from Wednesday, they focused on one such indicator.

From their update:

We’re always looking for simple, yet effective, ways to predict and confirm whether Wall Street is going to be bullish or bearish in the near-term on the S&P 500.

One method analysts and traders like to use to evaluate trader sentiment is intra-market analysis. That’s where you look at the individual sectors within the stock market to see which ones are outperforming and which ones are underperforming.

When sectors like the Financial and Technology sectors are outperforming, it usually means traders are bullish and the S&P 500 is likely to move higher.

Conversely, when sectors like the Utilities and Healthcare sectors are outperforming, it typically means traders are bearish, or nervous, and the S&P 500 is likely to consolidate sideways or move lower.

John and Wade note that, unfortunately, this type of intra-market analysis takes a tremendous amount of work. Plus, interpreting the results often involves lots of nuance.

So, they looked for a way to simplify it. This led them to narrow their analysis to the two sectors that focus on consumers: Consumer Discretionary and Consumer Staples.

“Consumer Discretionary” represents companies like Amazon and Home Depot. These companies do better when consumers have extra money to spend and feel confident that their financial future will continue to be strong.

“Consumer Staples” represents companies like Procter & Gamble and Walmart. These companies tend to do well even during economic slowdowns. That’s because people still need to buy basic items to live (shampoo, toothpaste) despite a souring economy.

Back to John and Wade for why this comparison can be insightful:

Consumer spending accounts for approximately 70% of U.S. gross domestic product (GDP), so why not focus on the largest driver of the U.S. economy?

When consumers are confident in the economy, they tend to spend more on discretionary items, like a new pair of shoes or a new car.

On the flip side, when consumers are uncertain about the economy, they tend to pull back on their discretionary spending, and only spend money on the staples for day-to-day living, like shampoo and toilet paper.

***How to analyze consumer spending, and what it’s telling us today

John and Wade find that the easiest way to analyze the performance of these two consumer-related sectors is to create a relative-strength comparison chart.

Specifically, they’re comparing the Consumer Discretionary Select Sector SPDR ETF (XLY) and the Consumer Staples Select Sector SPDR ETF (XLP), and asking the question “which of these ETFs is doing better?”

When the XLY/XLP relative-strength chart is moving higher, it indicates XLY (Consumer Discretionary) is outperforming XLP (Consumer Staples). A downward move indicates the opposite – XLY is underperforming XLP.

John and Wade note that when the chart is in an uptrend, or is bouncing up off support, it signals the S&P 500 is likely to be supported by bullish pressure.

Conversely, when the chart is in a downtrend, or is bouncing down off resistance, it signals the S&P 500 is likely to encounter more bearish pressure.

So, what does this comparison chart tell us today?

From John and Wade:

The chart has been consolidating, as XLP has been regaining strength. It has gone back and forth a bit, but the general direction of the consolidation range has been a slight downtrend.

This indicates some increased bearish pressure is being applied to the S&P 500, and we think it is related to rising interest rates.

We have been watching the 10-year Treasury Yield (TNX) as a barometer for interest rate expectations. As you can see in the blue line in Fig. 2 below, the TNX broke above resistance at 1% in early-2021, came back down and re-tested that level to see if it would hold as support in late-January and then shot higher for the next two months.

Fig. 2 – XLY/XLP Relative-Strength compared to the 10-year Treasury Yield (TNX) – Chart Source: TradingView

This increase in the TNX coincided with a weakening of XLY and a strengthening of XLP, as traders started to rotate money out of high-flying Tech stocks and other consumer discretionary stocks and started to rotate money into undervalued consumer staples stocks.

This inverse relationship – where one chart goes up while the other chart goes down – has held during this consolidation range on the XLY/XLP chart. When the TNX rises, XLY/XLP falls, and vice versa.

In other words, when interest rates drop, consumer discretionary stocks strengthen. When interest rates climb, consumer staples stocks strengthen.

***As for where the market goes next, all eyes on the TNX

John’s and Wade’s analysis boils down to one principal takeaway…

When the 10-year yield rises, watch out for bearish pressure on the S&P.

So, what’s one of the biggest influences on the direction of 10-year yield?

The Federal Reserve, and what it decides to do about its bond purchases.

Right now, the Fed is buying $80 billion of Treasurys and $40 billion of mortgage-backed securities each month. It’s doing this to support the economy.

The central bank has noted that it wants to see “substantial forward progress” before tapering these purchases. But the Fed is walking a fine line.

Historically, tapering would not be well-received by the market. You might recall the Taper Tantrum of 2013, when then-Federal-Reserve-Chairman Ben Bernanke tried to unwind the Fed’s accommodative asset purchases.

Market participants went into a tailspin at the prospect of no more easy money, causing the 10-year yield to surge 1.40 percentage points higher over roughly four months.

Even though Powell doesn’t want this, a taper might finally be off on the distant horizon.

From MarketWatch:

A number of Federal Reserve officials said at the central bank’s late April meeting that it could soon be time to begin talking about talking about scaling back its massive asset purchases, according to minutes of the discussion released Wednesday.

“A number of participants suggested that if the economy continued to make rapid progress toward the committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases,” the minutes said.

While not a major step, economists said it suggests the Fed may start to talk about when to make a plan in coming months.

This is something we’ll have to keep an eye on, since it stands to have a major influence on the 10-year yield…which would impact the stock market…which would impact your portfolio.

Looking forward, as we head into summer, here’s John’s and Wade’s bottom line:

If the TNX continues to move higher and challenge its previous high of 1.77%, we expect consumer discretionary stocks (XLY) will weaken and consumer staples stocks (XLP) with strengthen, which could pull the S&P 500 lower.

If the TNX holds where it is, or starts to pull back, watch for XLY to outperform and for the S&P 500 to find support.

As I write, Friday morning, the TNX yield is 1.635%. We’ll keep you up to speed here in the Digest.

Have a good evening,

Jeff Remsburg