Economic and Market relationships can be utilized to derive an outlook.
Such relationships include but not limited to asset and sector rotation, S&P 500 P/E valuations and market breadth.
Using these relationships it is expected that (SPY) will decline by at least 5% and (IEF) increase 6.16% over the next 3 months.
Some relationships just click. The push and pull of a magnetic field, the use of force in a lever and basic chemical reactions all exist to produce results that can stand the test of time. These are known as click relationships as they occur naturally. In finance, there are "click' relationships that can aid in determining a forecast for the financial markets. The stock market tends to predict future economic performance; bond prices tend to sell off before stock prices; market breadth divergence can denote bearish or bullish signals, equity sector leadership tends to aid in determining market tops and bottoms; analyzing historical price patterns can give a sense as to where they can go. Using these various relationships one can track the trend of the US equity and bond markets. Hence expectations are for the (NYSEARCA:SPY) to decline at least 5% from its high and retest the 180 price level. Estimates are also for (NYSEARCA:IEF) to retest the highs of 109.06 in May of 2013, which would see the US 10-year around the 2.30% price level. These projections are expected to be completed over the next 3 months.
Before drawing a conclusion on where the S&P 500 and the US 10-year yield will be in the next three months, a canvas must first be mounted. Some context must be given, a sort of atmosphere for the click relationships. Latest figures show that the US economy expanded by merely 2.3% year-over-year (YoY) in the 1st quarter of 2014. In the prior quarter US GDP grew 2.6% YoY and in the 1st quarter of 2013, US GDP grew by 1.3% YoY. Chart 1 below shows US quarterly GDP over the past 5 years.
Chart 1 US GDP(%) YoY Jun-09 to Mar-14
So while the growth rate of GDP lost some steam, the momentum is still much more than the previous year. What attributed to this loss in momentum was the harsh weather conditions during the 1st quarter of 2014. This affected consumer spending and residential investment. Consumer spending grew by roughly 0.7%, which is considerably below trend. Residential investment was also depressed and it contracted by 5.8% in the 1st quarter, a -13% differential from the average growth rate of the prior four quarters. While recent data suggests the US GDP will bounce back in the 2nd quarter, the amount of time lost during the harsh weather conditions could never be regained and as such the 4th quarter 2013 GDP figure may have been a 12-month high.
US inflation remains low. US CPI rose 1.5% YoY in March of 2014, 0.4% higher than the previous month, and stayed the same when compared to March 2013. Core inflation rose 1.7% YoY in March 2014, 0.1% higher than the previous month, but lower when compared to March 2013. The rise was attributed to an increase in rent and food expense. The charts below show US CPI and core CPI.
Chart 2 US CPI (%) YoY May-08 to Mar-14
Chart 3 US Core CPI (%) YoY May-08 to Mar-14
Inflation remains below the Fed's 2% target, which reduces the probability of an increase in the fed funds rate. As such a continuation in the decline in the US 10-year is on the front burner. The click relationships remain strong.
Another click relationship is the unemployment rate and the reduction in Quantitative Easing (QE) by the Fed. US payrolls rose by 288,000 while the unemployment rate fell to 6.3% from 6.7%, albeit fewer people are looking for work. The chart below shows the US unemployment rate.
Chart 4 US Unemployment Rate May-08 to Mar-14
With the unemployment rate below one of the Fed's threshold of unemployment of 6.5%, expectations are for the Fed to continue reducing its asset purchases. The latest Fed statement indicates just that - "Beginning in May, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $20Bn per month rather than $25Bn per month, and will add to its holdings of longer-term Treasury securities at a pace of $25Bn per month rather than $30Bn per month". The reduction of QE can have adverse effects on the market as it is a reduction in stimulus. These actions need to be monitored very closely, particularly when GDP growth is off its highs, inflation is below target, the US 10-year appeared to have peaked at the beginning of the year and the S&P 500 is losing upward momentum.
Asset and Sector Rotations
Intermarket analysis dictates that bonds peak first, followed by stocks, followed by commodities, as seen in the chart below.
Chart 5 4-Year Business Cycle
While this cycle is characterized over a 4-year time frame, attempts are being made to use this phenomena over a quarterly time frame. Thus, the analysis is used in conjunction with other factors such as economic trends, S&P valuations and chart pattern analysis.
Over the past 12 months, the US 10-year made a high of 3.05% on January 2nd 2014 and it appears that the sell-off in bonds is over as it fell over 40 bps from those levels and is testing the 2.568% level for a move lower. The S&P 500 appears to have encountered resistance at the 1897.28 high, and is now topping out. The CRBQ ETF, the ETF which tracks the Thomson/Reuters CRB Index is still in an uptrend. Thus, given the positions of the 3 indices, it appears that we have passed stage 3 and have entered late stage 4 or early 5.
Table 1 Periodic Sector Returns
S&P 500 CONS DISCRET IDX
S&P 500 CONS STAPLES IDX
S&P 500 ENERGY INDEX
S&P 500 FINANCIALS INDEX
S&P 500 HEALTH CARE IDX
S&P 500 INDUSTRIALS IDX
S&P 500 INFO TECH INDEX
S&P 500 MATERIALS INDEX
S&P 500 TELECOM SERV IDX
S&P 500 UTILITIES INDEX
Table 2 Periodic Sector Leaders and Laggards
1Mth Top 3 Leaders
1Mth Top 3 Laggards
3Mth Top 3 Leaders
3Mth Top 3 Laggards
6Mth Top 3 Leaders
6Mth Top 3 Laggards
9Mth Top 3 Leaders
9Mth Top 3 Laggards
1Yr Top 3 Leaders
1Yr Top 3 Laggards
Table 1 and 2 above give the sector returns and the sector leaders and laggards for the S&P 500. From these tables we can see the leadership shift from the cyclical Industrial and Technology Sectors to the defensive Utilities and Consumer Staples Sectors. Also another point of note is the recent leadership in the Energy sector (1-month and 3-month). Leadership in the energy sector suggests that economic expansion is nearing completion as high oil prices threaten economic growth. Hence, these click relationships between the assets and sectors are suggesting a pullback in the S&P 500 and lower yields in US Treasuries.
S&P 500 P/E Valuations
The overvaluation of quarterly P/E valuations relative to its 1-year and 3-year averages tend to indicate sell-offs in the market. For example, when the market peaked in September 2007 the current quarterly P/E at the time was 17.10, while the 1-year and 3-year quarterly averages were 16.72 and 16.96 respectively. Also in March of 2000, another market peak, the current quarterly S&P P/E stood at 28.96, while the 1-year and 3-year P/E were 28.75 and 25.55. Currently the S&P quarterly P/E stands at 17.2302 while the 1-year and 3-year P/E stands at 16.57 and 14.93. The chart below shows the current quarterly 3-year P/E.
Chart 6 SP500 Quarterly P/E May-11 to Mar-14
These valuations suggest that the market is overvalued and is due for a pullback. As stated earlier, these valuations are not to be taken alone but rather in conjunction with the current sector rotation and price patterns.
Chart 7 SP500 1-Year Daily Chart
What is notable when looking at the chart above (the S&P 500 daily chart), is the bearish divergence in the 14 period RSI. Some divergence is also seen in the longer term MACD, but not as notable in the RSI. Then another item to note in the S&P 500 is the symmetrical triangle which formed between April 4th 2014 to now. The completion of the setup will give a breakout to either the upside or downside as the symmetrical triangle is neither a bullish signal nor a bearish signal but a signal of uncertainty. Given the information earlier stated it is more likely to move lower than higher. The pattern is giving a target of around 1800, a 5.4% move from the high. This can carry SPY towards the 180 price level.
Market breadth is also showing bearish divergence, which is not a good sign, as seen in the chart below.
Chart 8 NYSE Composite and NYSE A-D line
Chart 9 US 10-Year Yield Daily Chart
The US 10-year yield appears to have made a double top pattern setup (2 Mountain Top for the Japanese Candlestick Chartist) around the 3.00% level. After moving range-bound between 2.80% and 2.60%, it is retesting the 2.60% level. If it breaks below the 2.60% level, it is expected to move lower towards the 2.30% price level. The RSI and MACD are also confirming a move lower with the RSI below the 50 level and the MACD being negative. This can carry IEF towards the 109 price level.
These relationships of economic activity, asset and sector rotation, P/E valuations, market breadth and technical analysis click. They offer signs as to where the US market can go. Given the clicks expressed above it appears as though the S&P 500 may pull back and the US yields may move lower (IEF increase in value).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.