From the desk of Steven Strazza @Sstrazza
It’s been about a month since small- and mid-caps resolved to the upside and made fresh highs.
As we all are aware, these were simply massive head-fakes. We’re right back to where we started–stuck in the middle of the same range we’ve been in all year.
There was also plenty of evidence from our intermarket relationships and ratios to support these moves. Discretionary-versus-staples ratios broke to fresh highs. Copper versus gold. Stocks versus bonds. Inflation expectations. They all made new highs recently. But, just like most stocks on an absolute basis, many of these breakouts have since failed.
Of all these developments, it’s hard to argue that any is more important than the stocks-versus-bonds ratio retracing back beneath its Q1 highs. With long rates making new lows and stocks selling off, let’s talk about how we are approaching both of these asset classes right now.
Here’s the S&P 500 $SPY relative to long-term Treasury bonds $TLT, zoomed out to the early 2000s.
We’re looking at a beautiful base-on-base pattern that resolved higher in Q1. The ratio made a strong leg higher through Q2 as stocks aggressively outperformed bonds. The ratio peaked in May and began to coil in a tight continuation pattern. This makes a lot of sense, as most stocks also peaked and started to consolidate during the first half of the year.
When stocks are outperforming bonds, it’s usually a safe bet that they’re also working higher on an absolute basis. Just look at how strong the relationship is between the stocks-versus-bonds ratio and the small-cap Russell 2000 $IWM:
Both charts experienced a strong leg up into the beginning of the year. Then, they paused and began to consolidate in a tight range. And, just recently, both tried to make upside resolutions but were unsuccessful. Stocks aren’t just range-bound on an absolute basis; they’re also trading in a sideways range relative to their alternatives.
Let’s zoom in and look at some levels:
Notice how the ratio ran into resistance and began to consolidate at our upside objective at the 161.8% retracement. After a failed attempt to resolve higher, this week SPY/TLT undercut its former highs and is right back in its old range. Notice how momentum has been waning and was unable to achieve an overbought reading to confirm the new highs.
As long as the ratio remains in its current range and above the summer lows, our outlook on stocks versus bonds is neutral. If we violate the lower bounds, we’re looking for downside toward the base breakout level of 2.40. We want to be favoring bonds if and when this happens. On the other hand, if the ratio repairs the recent damage and reclaims last week’s highs, the alpha will be back with the stock market, and we’ll want to reposition accordingly.
For now, it’s just a mess. There is no relative edge between these asset classes.
For the better part of 2021, there have been stocks we’ve wanted to be buying. And there have also been stocks we’ve wanted to be selling. The stock market has been a mixed bag, and it’s only become more bifurcated as the year progresses.
When we look at the bond market, it’s the same story. There are short-duration bonds, which have done poorly as the short end of the curve has been playing catch-up to the long end. We can use the short-term treasury bond ETFs $IEI and $IEF to express this bearish thesis.
As long as the US 5-Year Yield $FVX holds above its first-half highs of 0.95%, we want to be sellers of short-duration bonds. We’ve already been short for months now.
But when we look at long-duration bonds, the picture is quite different. For example, TLT is currently challenging the upper bounds of its year-to-date range while the US 30-Year Yield $TYX breaks to its lowest level since January.
The 30-year is the cheat code here. As long as it’s below the summer lows around 1.80%, we’re buyers of TLT above 151 with a near-term target of 162.
There are stocks we want to be buying and stocks we want to be selling. And there are bonds we want to be buying and bonds we want to be selling.
As far as any edge between the two on a relative basis is concerned, it really depends on what stocks and what bonds we’re talking about. The S&P 500 versus long-duration Treasury bonds is a hot mess right now. There’s nothing actionable on a relative basis until the present range resolves in one direction or another.
The takeaway here is simple: If yields continue moving in opposite directions, we’re buying and selling bonds of different maturities.
The levels for bonds and interest rates are clear and well-defined. If the 30-year reverses higher, we have no business buying long bonds. In the case this happens, and we’re proven wrong, our downside is limited. And we should find out soon.
In the event the market comes under further pressure, we’ll likely be happy to own some Treasuries here.
Do we have this right? Let us know what you think!
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