After some brief weakness that threatened the uptrend, the market has roared back furiously and is on the verge of making new highs. Although the larger cap indexes such as the S&P 500 and the Dow Jones Industrial Average have been quite strong, many high beta indexes have significantly lagged since early March. The lack of bid in these more economically-sensitive areas influenced my cautious stance towards equities, which I detailed in this article.
Two weeks ago, the markets did experience some selling pressure, with the S&P 500 selling off almost 60 points. Despite the weakness, there were some constructive developments in terms of market internals. My interpretation was that stocks were being accumulated amidst the weakness. I provided my reasons for buying the dip in this article.
I think the next question is whether this strength in the stock market will persist or is it an opportunity to unload shares at temporarily elevated prices. Based on my interpretation of market conditions, I believe that this rally should be given the benefit of the doubt and traders should use weakness to add exposure.
Below the chart of the S&P 500 are three risk on measures. These are all currently in an uptrend off the market's lows. As long as these remain intact, I would not bet against the rally. The powerful, multi-month rallies in which almost all stocks participate, such as the recent one from mid-November to February, are characterized by the outperformance of high beta sectors.
The first risk measure compares the cyclicals to the S&P 500. Watching the cyclicals is important because they are the most leveraged to the economy, thus their underperformance means that traders are becoming less optimistic about future economic conditions. Many cyclical stocks such as industrials and steel stocks have been brutally sold off with many below March 2009 levels. Some rotation into these would be a healthy development for the market.
The second shows the ratio of commodities to bonds. Commodities are a proxy for the global economy and thrive when demand is rising. In contrast, bonds are the ultimate risk-free asset. Bonds have been on a stellar run with the ten year yield around 1.70%. From mid-March, the ten year yield has fallen nearly back to its November levels. Of course, this at a time when the S&P 500 is more than 250 points higher. Nevertheless when commodities have outperformed bonds, it has been the best time period to own risk on assets. We are currently in such a period.
The third ratio compares the equal weighted S&P 500 to the S&P 500. I think looking at the equal weighted S&P 500 is important as the larger companies can skew the performance of the S&P 500. It is similar to comparing the performance of the small caps, mid caps, and large caps. This is one measure of the liquidity in the market which is required for large, trending moves with broad participation.
All in all, these ratios seem to be moving up which is one necessary but not sufficient ingredient for the market to trend higher.
Comparable ETFs for these indexes mentioned are the SPDR S&P 500 ETF Trust (SPY), SPDR Dow Jones Industrial Average ETF (DIA), PowerShares QQQ Trust, Series 1 (QQQ) and the iShares Russell 2000 Index (IWM).
Another important "check" on the market's health is the performance of high-yield bonds. The strength in the bonds during the market's weakness gave me conviction in my bullish stance as my interpretation was that the selling was more of a profit taking nature rather than more serious. Currently, the high-yield bonds continue to move up past recent highs.
Although the large cap oriented indexes trended up during the last couple of months, the time period was more challenging, especially on an individual stock level. Many stocks in the commodity sector gave up all their gains from the previous rally and even more in some cases. Other stocks remained range bound.
I think if the conditions that we have enjoyed in the past few trading sessions continue to hold, then we will have a resumption of the market environment enjoyed from mid-November to early February. This would entail a broad, trending rally with shallow dips and participation across the board rather than concentrated in select stocks and sectors. If the factors listed above falter or we break the recent low of 1540 on the S&P 500, then I would reconsider my position.