From the desk of Steve Strazza @Sstrazza
Thank you to everyone who responded to this week’s mystery chart.
We had mostly “do nothing” responses again this week but buyers or potential buyers came in close second, many of which said they were waiting for confirmation of the momentum divergence and failed breakdown before taking action.
We only had a few sellers, which is interesting because that’s the camp we’d fall into as long as prices remain below support.
One of the main reasons for our bearish bias towards this chart is the fact that it’s been in a long-term downtrend and consolidations tend to resolve themselves in the direction of the underlying trend.
Only one respondent mentioned this and his explanation was quite thoughtful and unique from the others. Not only did he mention the downtrend and that he’d be selling if prices remain below support, but he also cited the fact that the momentum divergence may have already worked itself off through time.
This is similar to how we’re thinking about it, so with that as our backdrop let’s take a look at this week’s chart.
This is a ratio chart of Frontier Markets (FM) relative to the All-Country World Index (ACWI).
Click on the chart to enlarge view.
We figured this chart would present an excellent thought exercise because anyone who is buying this breakdown is betting that Frontier Markets, some of the weakest economies around the world, will outperform International and US equities as a whole.
US Equities make up over 60% of the All-Country World Index and the US has drastically outperformed just about every area of International Equities for 10 years now. Considering this new context, would you still be buying this and betting on a reversal in the decade-long downtrend in the riskiest area of global equities relative to the broader market?
How about doing this in a market environment where the S&P 500 (SPY) has fallen almost 10% in just five days?
Highlighting US outperformance relative to Developed Markets, Emerging Markets and individual regions such as Latin America is something we’ve been doing for years now.
Outside of some short-term mean reversion trades, we’ve outlined many pairs trades in the S&P 500 relative to other International Country ETFs as a way to express the structural view that the US remains in the driver’s seat, the most recent of which you can read here.
Some of the main reasons we’re not betting on this breakdown failing have nothing to do with the chart itself, but instead what’s happening with similar inter-market ratios.
Below we’re looking at the performance of other ratio charts that analyze peer-groupings such as Frontier Markets relative to the S&P 500 (FM/SPY) and Emerging Markets relative to the All-Country World Index (EEM/SPY).
As you can see, these charts look quite similar to the one we’re discussing, and they’ve already broken down. The US drives the performance of the All-Country World Index and Emerging Market stocks have similar risk-on characteristics to Frontier Markets, so the Frontier Markets vs All-Country World Index ratio is likely to resolve in the same direction (lower).
Another thing to notice is these ratios have worked off long-standing bullish momentum divergences in the past, never confirming them through price, and instead breaking lower. We see little reason to believe things will be any different for the current setup in Frontier Markets vs the All-Country World Index.
We also have to consider the market environment we’re in currently. Frontier Markets are viewed as some of the highest-risk equities so we would expect them to underperform in a down market like we’re experiencing now.
On the off chance that this breakdown does fail and results in a short-term move higher, Frontier Markets will still have a lot to prove when it comes to the structural trend. As usual, your approach to this chart all comes down to your timeframe and what your objectives are.
The bottom line is that regardless of what happens with equities on an absolute basis, there is still plenty of evidence supporting the view that the US remains the best house on the block.
Would you rather be buying US or International Equities here? Let us know.