Don’t ignore these stock market warning flags

From Ben Morris, Editor, DailyWealth Trader:

Markets move with a sense of order…

Investors buy certain assets when they sense danger… And they buy other assets when they’re gunning for big gains.

When demand (money) shifts toward one asset, it’s shifting away from (out of) others.

This dynamic creates “correlations.” Certain assets tend to move up and down together. (We say these assets are “correlated.”) And other assets tend to move opposite one another. (These assets are “inversely correlated.”)

Think about how, because of their similarities, gold and silver tend to move together… or how gold and the U.S. dollar, because of their differences, tend to move opposite one another.

Professional traders often keep tabs on correlations to get a feel for how the market is behaving. When normal correlations break down, it’s a sign that there’s more to the story… that something may be brewing beneath the surface.

Today, we’ll look at how some of these normal market correlations have broken down… And we’ll explain what it means for our trading.

Let’s start with bonds…

Investors see bonds as safe because the bond issuer is legally obligated to pay the bond buyer back… usually with interest. Even if the issuer goes bankrupt, the bond buyer often has a claim on the issuer’s assets.

That’s not true with stocks. Companies don’t have any obligation to return a shareholder’s investment. And if the company goes broke, the stock goes to zero… The shareholder is out of luck.

For this reason, at least over the span of days or months, bonds and stocks are usually inversely correlated. In extreme cases, like bull market mania peaks and the sharp bear markets that follow, these correlations can last years…

For example, during the last big run of the dot-com bubble – from August 1998 through August 2000 – the benchmark S&P 500 Index soared 59%. The 10-year U.S. Treasury (a major benchmark for bonds) dropped 14%. When the bubble burst, the S&P 500 fell 46% through late 2002… And 10-year Treasurys shot 16% higher. (For 10-year Treasurys, these are enormous moves.)

This same correlation played out before and after the 2007 financial crisis peak.

This inverse relationship between bonds and stocks is one of the most followed correlations in the world. At the end of 2015, the global bond market was worth around $180 trillion… or nearly three times as large as the global stock market (worth around $64 trillion). So when the bond market moves, the world’s best investors pay attention…

With that in mind, consider the recent action in 10-year Treasurys. They’re up about 2% this year…

Based on the normal correlation, you would expect stock prices to be lower this year… But they’re not.

Next, let’s look at the normal inverse correlation between the Japanese currency – the yen – and U.S. stocks…

You can think about currencies like stock prices for countries. When times are good in a country (or at least better than in other countries), its currency often rises.

The yen is one of the most commonly traded currencies in the world. Investors see it as a good, low-risk alternative when they don’t want to hold U.S. dollars… or other U.S.-based assets, like stocks.

So when U.S. stocks fall, traders often sell shares and convert their dollars to yen. (The same goes for other major currencies.) As you can see in the chart below, the yen has rallied more than 5% since it bottomed in February…

Once again, a yen rally normally corresponds with a drop in U.S. stocks… But not this time.

Finally, let’s look at consumer-staples stocks. Consumer staples are companies that sell everyday basics like soda, toilet paper, and cigarettes. People buy these things regardless of how well the economy is doing… So investors often consider it a defensive, or low-risk, sector.

For this reason, consumer-staples stocks often underperform the broad stock market during bull markets… And they tend to outperform in times of distress.

This isn’t an inverse correlation. But usually, if consumer staples are doing well, it means that investors are worried… and are selling stocks in riskier sectors.

The popular Consumer Staples Select Sector SPDR Fund (XLP) holds shares of companies like Procter & Gamble (PG), Philip Morris (PM), Coca-Cola (KO), and Wal-Mart (WMT). It’s a good way to gauge the sector as a whole.

As you can see in the chart below, XLP recently broke out to a new all-time high. It’s up more than 10% this year…

So bonds are up… The yen is up… And defensive consumer-staples stocks are up. These assets are waving a warning flag.

Under normal conditions, U.S. stocks would be lower. Instead, they’re up 8.5% this year and trading at all-time highs…

What does all this mean?

So far, U.S. stocks have shrugged off the rallies in our “warning flag” assets. As we noted yesterday, the trend is up… And we can’t know how long it will continue.

But when normal market relationships break down, it usually means something unexpected is brewing beneath the market’s surface… And it’s a good idea to be cautious.

If the rallies in all three warning-flag assets continue, we may start to take out some more “stock market insurance.” This may be in the form of short trades, pairs trades, or other trades that have a good chance to make money when stocks fall. This will help protect our primarily bullish portfolio.

But if our warning-flag assets start to turn lower – particularly Treasurys and the yen – we would expect the current rally in stocks to accelerate

In DailyWealth Trader (DWT), we’re still bullish on stocks. But we need to pay attention to what the market is telling us…

And right now, it’s saying that the short-term picture may not be as rosy as meets the eye. Trade accordingly.

Regards,

Ben Morris and Drew McConnell

Crux note: This week in DailyWealth Trader, Ben told his readers his latest advice on gold and gold stocks. For a limited time, you can try out Ben’s daily letter risk-free. Get all the details here.

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