When it doesn’t pay to take stock
At the beginning of the year we highlighted how correlations between asset classes were expected to breakdown further. Equities, yields, the US dollar and commodities continue to diverge from their normal inter-market behavior in a very unique way.
“First a prolonged correlation breakdown only occurs when a global trend is near its end as the fundamental drivers that glue markets together lose their potency. Secondly, the particular interaction of the four asset classes and markets within has only been seen twice before: in 1929 and particularly 1987.”
This breakdown has started to spill over into the stock market, where stocks and sectors are moving very disparate paths. Even highly correlated stocks such as FAANG have wildly different patterns and performances in recent weeks.
This is partially influenced by earnings season, and stock specific catalysts such as the Facebook (FB) data breach, or President Trump’s attack on Amazon (AMZN). Meanwhile consolidation patterns in the indices mean there is no broader catalyst to lift all stocks the same time.
However, it is the divergences in the sectors and types of stocks which provide the most insight to our analysis. The S&P500 is correcting sideways and appears in danger of breaking down, which should favour defensive stocks and sectors such as Consumer Staples (XLP). Yet these are actually being hit the hardest.
XLP is rate sensitive, but note it made new bull market highs in early 2018. It is not a simple bond-like sector such as the REIT ETF (IYR), which has fallen ever since bonds topped in 2016.
So what has caused this shift in 2018? Well, this for a start:
The break from a multi decade downtrend in 10 year yields is significant. Many defensive stocks and sectors were able to rally alongside rising yields over the last stage of the equity bull market, but only up to a point. Interestingly, we have seen this behavior before.
Defensive, dividend stocks such as Johnson and Johnson (JNJ) were unfazed by the rally in yields for most of 1987 and rallied with them right until they broke higher in August ’87. This break higher was the last straw, causing JNJ to top and roll over. Its dividend yield trended higher into the eventual crash.
This exact behavior is being repeated in today’s market. JNJ rallied to new all time highs in early 2018, but as yields broke above the channel and the previous highs, JNJ reversed into a steep decline.
One of XLP’s largest holdings, Coca Cola (KO), again topped in 1987 as yields broke out …
… and repeated this in 2018.
Price structure is also comparable.
We could therefore conclude that XLP and many dividend stocks have actually topped as the pressure of rising yields has reached a tipping point. If the 10 year yield is at 3%, why would anyone want to hold Procter and Gamble (PG) with a 3% yield? Price must fall to lift the yield.
The topping of these stocks warns of an approaching stock market reversal. However, this elusive peak could be some way off, yet. Momentum stocks such as Apple (AAPL) and Intel (INTC) continued higher in 1987 after the likes of JNJ and KO, and even the broader market had topped.
With the huge market weighting of FAAMG and the potential for a final large rally, calling a stock market top seems premature. Additionally, while PG (and others) may have topped, the initial declines look nearly complete, and their recoveries will help lift the market.
One last point: due to the recent falls, some defensive stocks have quite attractive dividends. AT&T (T) for example has a dividend yield of over 6%. Yet looking at the behavior of comparable stocks in 1987 tells us yields can get a lot better in a market correction. There will be nowhere to hide.
Good Luck and Good Trading
Chief Stocks Analyst
Ed Matts is away this weekend, speaking at ShowFXWorld Prague
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