What looks to be taking shape across the board in American markets is the development of intermarket head and shoulders patterns. The pattern makes sense intuitively when considering the underlying environment. Markets rallied into the belief that the worst outcomes were less bad than previously thought, and that the euro was shaping up during August. The head was formed when QE3 was announced and central banks went to great efforts to stimulate. Lastly, the right shoulder formed when markets refused to believe that the good times were over. A distinct break has yet to develop/confirm the pattern, but it seems possible. Market sentiment has turned negative upon earnings season and the weak global forecasts.
The first chart is of equal weight S&P 500 index (RSP) over ten year treasuries (IEF). This indicator is highly correlated with risk, and it signals shifts in capital flow between US equity and fixed income. The chart shows the aforementioned pattern, and a significant break looks probable. Certain equities may outperform others, but due to the equal weighted nature of the numerator, earnings season must be positive as a whole for true strength.
The next chart kind of touches on a point I made above. Instead of equal weighted indexes over debt, this indicator focuses on equal weighted indexes over weighted (SPY). A rising of all equities versus just a handful of large weights signals strength. This indicator has shown a distinct head and shoulders pattern, but no break as of yet. Equities has certainly hit a hurdle, and many people are looking at obstacles that lie ahead rather than the successes of the past. Watch this indicator in following weeks to determine the severity of market weakness.
A move into the US treasuries realm also confirms the belief of impending weakness. The indicator below is that of short-term treasury bills (BIL) over 30 year treasuries (TLT). A contraction of yields is negative for market sentiment as a whole, and this collapse looks to be taking shape in the form of a head and shoulders. Bills have shown strength over the accommodative past few months, but have recently broken trend. As this indicator falls, look for equities to follow suit and yields to contract in longer-term treasuries.
The final indicator moves back into equities to judge the inherent risk sentiment in markets. The VIX (VXX) has a strong negative correlation to risk, and signals when money is pouring into hedging strategies. An indicator that correlates with VIX is utility stocks (XLU) over broader markets. When this indicator shows strength, it means investors are favoring defensive strategies. Considering this, the indicator has indeed shown strength lately. The steady uptrend signals the eventual decline or lack of strength. Watch the gradual advance to weigh on markets in coming weeks.