Cracks Beneath the Market's Surface

NEW YORK (TheStreet) -- Although the S&P 500 hit another all-time high last week, the picture beneath the surface is much less bullish.

In 2013, what was going on beneath the surface didn't matter. Stocks were moving higher on strong momentum. Nothing else mattered to investors. But, alas, we are not in 2013 anymore. The S&P 500 is close to flat year-to-date; it was up over 9% at this point in 2013. Investors don't seem to be giving equities the same benefit of the doubt as they did last year.

We last saw weakness beneath the surface in mid-January, and a 6% correction followed shortly thereafter. The S&P 500 marched higher in February in recovering from that correction, but has stalled over the past few weeks as we are starting to see signs of weakness.

First, long-term U.S. Treasury yields are moving lower. While many are talking about a "rising rate" environment after the Federal Reserve's statement last week, what we are really seeing is a flattening of the yield curve.

Yields on shorter-duration bonds, such as the two-year Treasury note, are moving higher, while yields on longer-duration bonds, such as the 30-year Treasury bond, are moving lower. This flattening tends to be a contractionary signal for the equity markets.

Second, we are seeing weakness in the ratio of cyclical sectors shown by the Consumer Discretionary Select Sector (XLY), an exchange-traded fund, relative to defensive sectors shown by the Consumer Staples Select Sector SPDR (XLP), another ETF.

The ratio has been falling since early March and the consumer-discretionary sector is underperforming the consumer-staples sector thus far this year. Similar to a flattening yield curve, when this ratio is persistently falling, it tends to be a contractionary signal for the equity markets.


Finally, while the S&P 500 has been hitting new highs, leading stocks or high momentum names have not been confirming an uptrend. When stocks that once led the market diverge from the market, it is often a cautionary signal.

In the top panel chart below, you'll notice the iShares MSCI USA Momentum Factor ETF (MTUM) has been moving sharply lower vs. the S&P 500 SPDRs (SPY).

Additionally, the leading segment within the momentum area over the past few years -- biotech stocks -- peaked back in February and are also moving sharply lower as you can see in SPDR S&P Biotech Index ETF (XBI) in the bottom panel of the chart below.

These signals alone warrant some caution here. Additionally, you have an index in the S&P 500 that has not suffered a pullback to its 200-day moving average since 2012, the longest such stretch since 1995-96 and one of the longest stretches above the 200-day in history. That is another way of saying that U.S. equities are still extended here and investors should not be surprised to see a deeper correction at some point this year.

Whether that correction is beginning here remains to be seen, but until the above signals show signs of stabilizing, I would tread more cautiously.

At the time of publication, the author had no position in any of the funds mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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