Divergences of both market breadth and DJ Transportation Average with the major equity averages along with rising interest rate concerns suggests the risk of an overall market decline has risen sufficiently to consider reducing further interest rate exposure?
Market Breadth
Last week we?included a caution that an important developing divergence should be carefully watched when the McClellan Oscillator Summation Index reported by McClellan Financial Publications decline by 579.87 down to 1956.97. Since then the troublesome decline continues, down another 867.49 points to 1089.48, including 451.84 just this week as the downward momentum increased. If the number of issues declining compared to those advancing defined the market rather than the index value then a downtrend is already well underway.
iShares Transportation Average (IYT) ?up 3.85 or 2.85% for the week this ETF tracks the important Dow Jones Transportation Average Index measuring the performance of transportation sector US equities and considered a leading economic indicator. According to the widely followed Dow Theory, the transports and the Dow Jones Industrial Average should move in the same direction while divergences signal a possible trend change from a Dow Theory perspective.
The bulls welcomed last week?s gains as IYT had closed below 150 the previous week however, it remains well below the critical 155 level now defining a four point downward sloping trendline beginning with the March 20 high at 165. Unless IYT soon recovers to close back above 155 this important divergence spells looming trouble for the major equity indexes.
ProShares UltraShort 20+ Year Treasury (TBT) was up 3.70 or 7.96% advancing every day last week except Thursday.
Longer-term bonds are more interest rate sensitive than those with shorter maturities and ProShares UltraShort 20+ Year Treasury with two times the inverse (-2x) of the daily performance of the Barclays U.S. 20+ Year Treasury Bond Index adds to the sensitivity making it easy to relate to increasing interest rates. Look at this updated chart.
After spiking higher on March 6 labeled A above, and then quickly reversing, the same upward movement appeared again before May 8 labeled C, both before nonfarm payroll reports. The exception occurred with the March report released on Friday April 3 labeled B, a day when the markets were closed, so it did not receive the same attention and since the weak report must have been anticipated when trading resumed April 6, the response was negligible. For Friday?s report, the pattern of advancing into the release continued labeled D, taking it right up the previous high just above 50.
While the pull back after the May report occurred after making a new high above 50 it eventually declined back to support at 46 on May 29 before running up into the nonfarm payroll report Friday. The May 29 pivot at 46.47 and the April 17 low at 40.97 now define a new upward sloping trendline, USTL at about the typical 30 degree angle that often defines long-term uptrend that can be used as a trendline support guide for the next likely pullback that should temporarily help equities and commodities until TBT breakouts out above 50.
For a comparison, the alternative iShares 20+ Year Treasury Bond (TLT) 117.60 declined 5.11 points or 4.16% last week vs. +7.96% for TBT.
US Dollar Index (DX) down .60 for the week, but up .85 Friday as it may have completed the 4th Elliott corrective wave near the 98 level, described in Digest Issue 21 “S&P 500 & US Dollar Indexes [Charts]”. Then as expected, it began declining before abruptly reversing higher once again after Friday?s nonfarm payroll report. Consistent with lower Treasury note and bond prices and higher interest rates, the dollar response implies increasing expectations for Federal Reserve action to begin normalizing interest rate policy this year despite mixed to negative non-monetary indicators earlier in the week that were described as terrible up until Friday. A further advance above 98, should it continue would be negative for the major equity indexes due to foreign exchange translation losses along with commodities priced in dollars, especially crude oil.
Market Strategy
While the historical record for June is insufficient by itself to justify selling equities the economic outlook until Friday?s nonfarm payroll report was less than encouraging and likely contributed the recent weakness in the DJ Transportation Averages.
The combination of breadth and DJ Transportation Average divergences along with expectations for rising interest rate and US dollar strength are enough to challenge the major equity indexes especially interest rate sensitive sectors and companies. Perhaps these are the ?four horsemen of the apocalypse? and need careful analysis.
If so, consider implementing some hedging strategies that may include selling interest sensitive sectors like utilities, MLPs and REITs along with some long July VIX 16-strike call options priced Friday at 1.68 with an implied volatility of 74.19.
Market Summary
Divergences of both market breadth and DJ Transportation Average with the major equity averages along with rising interest rate concerns suggests, the risk of an overall market decline has risen sufficiently to consider reducing further interest rate exposure while hedging any remaining portfolio risk especially since the S&P 500 Index is below the upward sloping trendline and 50-day moving average.