As Market Trends Reverse, Choices Loom

May 15, 2015

 

European Bonds

This market has been on a very strong trend for longer than just the past few months. The short end of European yield curves resides in negative yield territory.

 

The benchmark German 10-year rate has been on a smooth ride lower since the end of 2013, where rates went from just shy of 2 percent all the way down to a measly 0.07 percent by April 17. The downward moves in Italian and Spanish yields have been even more impressive, trading from 4 percent to just shy of 1 percent over the same period.

 

While not listed in the U.S., the iShares Euro Government Bond 7-10 Year ETF (IBGM) was up 20 percent since the end of 2013 in local currency terms compared with a 12.4 percent gain in the iShares 7-10 Year US Treasury Bond ETF (IEF | A-51).

 

However, since mid-April, the bottom has fallen out of this market. The yield on the German 10-year note has spiked nearly 50 basis points since April 20, completely wiping out the year-to-date move lower. Similar moves have been felt in other European markets, leading the European-listed IBGM to trade 2.7 percent lower since April 20, compared with IEF’s decline of 1.7 percent.

 

So is the lower rate move in Europe now over?

 

Based on remarks from a popular market analyst, this move actually could have been expected. As he notes, the markets here in the U.S. saw similar rate spikes right after the start of quantitative easing injections, but rates leveled off thereafter. Therefore, as the ECB is going down a similar QE path, it could be expected that rates abroad follow a similar trajectory.

 

Small-Caps Stocks

I interpret the outperformance of U.S. small-cap stocks as a bullish signal for the market. Relative strength in small-caps over the S&P 500 Index suggests investors are speculating rather than rotating to higher-quality large-cap names. During the first months of the year through April 15, the small-cap Russell 2000 Index was up 6.2 percent compared with the S&P 500 2.9 percent gain.

 

However, since mid-April, this trend has reversed, with the Russell 2000 down 3.1 percent versus a modest 0.6 percent gain for the S&P 500. While this underperformance does bring a bit of concern, a few factors could stem the bleeding. One of these factors is the small-cap-to-large-cap ratio, which looks to be at a resistance level.

 

 

The bottom half of the chart below shows the ratio over the trailing 12 months. The ratio is currently at 1.5. This is the same level we saw maintained for extended periods in summer 2014 and earlier this year. If we see this ratio level off, small-caps should at least keep par with their large-cap counterparts.

 

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