Weekly Update

July 22, 2016 Update

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Risk-on or risk-off?

Graphical ratio or “pairs” analysis is a quick way to see what preferences the market is displaying. Generally speaking, we are looking for whether the market is embracing a “risk-on” posture – e.g. choosing riskier assets to invest in – or a “risk-off” posture – showing a preference for lower-risk, defensive assets. We can tell the market’s preference by charting two assets, indexes, ETFs, funds, or any other pair in a ratio chart as shown in Chart 1 below. Here, we are comparing the high-beta (higher risk) ETF and the low-volatility (lower risk) ETF. The lower-volatility stocks have been the market’s choice for most of the past 18 months as shown by the declining line in the chart below (we have put low-volatility in the ratio’s denominator. Strength in the denominator is shown by a falling trendline.).

Chart 1: Market has been focused on lower-volatility (defensive) stocks

Market has been focused on lower-volatility (defensive) stocks

Lower-volatility stocks tend to carry larger dividends and will benefit from falling interest rates. Interest rates are typically falling in a more cautious economic environment. We can also look at bonds in the same way by comparing the performance of higher-yield corporate bonds with those of higher-quality, lower-yield bonds. If the market prefers the higher-quality bonds that shows less willingness to take risk. When high-yield bonds are outperforming, it shows investors are willing to take more risk which usually also translates into strength in the stock market.

Chart 2: High-yield bonds compared to higher-quality bonds

High-yield bonds compared to higher-quality bonds

We can see that high-yield bonds have been stronger for much of this year. But they are recovering from what has generally been a two-year bout of weakness compared to lower-yield, higher-quality corporate bonds.

From a stock sector perspective, we can look at the behavior of two different types of consumer stocks. Consumer spending dominates the U.S. economy at about 70% of economic activity. If consumers are spending more, as they would in a healthy economy, we would expect more economically cyclical or “discretionary” stocks like restaurants and retailers to outperform. If the economy is weaker and/or investors are more cautious, we would expect the stock market to show a preference for consumer staples stocks, those which sell basic home necessity goods like toilet paper, toothpaste, etc. The Chart 3 below compares these two stock sectors showing the preference for more defensive consumer staples stocks for the past nine months though cyclical stocks had been generally stronger for 2 of the past 3 years.

Chart 3: Consumer cyclical stocks versus consumer staples

Consumer cyclical stocks versus consumer staples

We will post a few more of these comparative charts and leave you to create your own as you like. The last one we will discuss is a comparison of our focus Nasdaq 100 stock market index which holds most of the technology stocks, and increasingly overlap consumer cyclical/discretionary, measured against an index that holds the top 100 largest companies and therefore is somewhat more diversified and less risky. We can see that Chart 4 confirms the market’s desire throughout 2016 so far for lower risk stocks. As with the charts above, it appears that riskier parts of the market are making an effort to break through and take over driving the market higher. This shift will be necessary if stocks are to continue building on their recent strength.

Chart 4: Nasdaq 100 stocks compared to top 100 largest stocks

Nasdaq 100 stocks compared to top 100 largest stocks

Value vs Growth and commodity strength

Just a couple of extra (BONUS!!!) charts for you that are also in the comparative ratio format. We look at value stocks compared to growth stocks. Note that banking stocks, which have generally lagged the market over the past 5+ years, are a big chunk of the value group. Secondly, the stark trend of commodity-related stocks clustered in the emerging market stock space. International compared to U.S. markets look very similar we note.

Chart 5: Value versus growth stocks

Value versus growth stocks

Chart 6 :Emerging market versus S&P 500 stocks

Emerging market versus S&P 500 stocks

Market Update

Stocks kicked off the week with a lightly traded session that still managed a +0.2% gain. An acquisition in the semiconductor space and decent earnings from Bank of America (BAC) outpaced an overnight scare in markets when a failed coup attempt in Turkey temporarily rattled investors. Tuesday saw a weak session in Europe with a pair of German reports portraying that nation’s economy still struggling. The U.S. markets were bolstered by a surging housing starts report.
The net effect was a flat session as markets continue digesting recent market strength. Wednesday’s session benefited from a better-than-expected earnings report from Microsoft (MSFT) in the U.S. and SAP in Germany. The happy news from the two software companies sparked a rally in tech shares with the Nasdaq Composite popping higher by +1.0%. Thursday saw the Dow Jones Industrial Average winning streak finally come to an end after nine sessions. But buyers were ready to jump on any dip and did so to limit the day’s pullback to a slim -0.3%. The buying continued into Friday’s session to the tune of a +0.5% advance and leave the week in positive shape after four prior days of generally flat trading.

Warm wishes and until next week.