Long-term U.S. Treasury bonds continue to perform very well in the market, which rarely happens while stocks are rising. As I have pointed out several times in the Chart Advisor, yields tend to rise with stocks, which means that bonds should be moving lower.
The iShares 20+ Year US Treasury Bond ETF (TLT) is currently forming a very interesting bullish cup and handle formation. This is a slightly smaller version of the same pattern that formed and completed in late May, which I pointed out in the Chart Advisor issue on May 23.
I recommend using a Fibonacci retracement anchored to the top and bottom of a cup and handle pattern to make an estimate for the eventual price target which, in this case, is $134.17, as shown in the following chart. The last two times this pattern has formed, the ETF's share price overshot the target, so this may be a somewhat conservative estimate.
The bullish signal in bond prices is interesting on its own, but it also highlights the persistent issue of rising bond prices in a bull stock market. One explanation could be that business investment has been tightening a lot over the past three months while this divergence has been worsening.
If businesses aren't investing, then they aren't borrowing. If banks aren't seeing a lot of demand from borrowers, then interest rates fall, which could explain a lot of what we are seeing this quarter. We probably won't know for sure until the big banks start to report their earnings next week.
However, what I think we can say is that, despite higher highs on the S&P 500, the underlying fundamentals are still showing some cracks that could worsen in the short term. Taking advantage of some of that uncertainty through investments in income-paying stocks and bond ETFs might make sense as a diversification strategy.
The S&P 500 spiked to new highs on Monday as investors reacted to positive comments about the trade talks between the United States and China. However, even though small caps gained, the Russell 2000 is still far from its prior short-term highs and nowhere near its all-time highs.
I have applied a stochastics oscillator to the following chart of the Russell 2000. This indicator was originally developed by technician George Lane to evaluate price momentum and find bullish and bearish divergences. Although it is not completed yet, you can see the potential for a series of higher highs on the price to be matched with falling highs on the oscillator (i.e. bearish divergence) to be completed in the next day or two.
I would like to point out that this kind of signal isn't a precursor to a bear market, but it often signals a short-term retracement that could bring prices back down to support. You can see a similar pattern that completed in April and May. Again, this is a cautionary signal for bulls to consider their risk exposure carefully.
Risk Indicators – Earnings Growth
Already in this issue, I have pointed out two risk indicators that are a little bearish. Rising bond prices and bearish divergences deserve attention, but I expect longer-term guidance from earnings to be a more important signal.
Historically, sustained bear markets are preceded by negative quarterly earnings growth on a year-over-year basis. The fact that earnings didn't decline in the fourth quarter of 2018 is one of the big reasons the market bounced back so sharply in January through March of this year.
The bearish shocks in 2015 were accompanied by declining earnings growth rates, which you can see in the following chart. This is usually what we see when the market is due for a more prolonged period of flat or negative trading. The big declines in the first quarter of 2018 were also preceded by negative growth in the fourth quarter of 2017.
As I mentioned, earnings growth rates when compared to the same quarter of the prior year were still positive in the fourth quarter of 2018 but were heading toward negative territory. What you can't see yet in the finalized chart is that the first quarter's reports were virtually unchanged from the prior year, so it won't take much for the second quarter reports to be net-negative on a year-over-year basis.
This puts traders in an interesting situation. On the one hand, the risks of a potential decline in July and August are well known. However, we have to assume that some of that has already been priced into the market. I think the Fed's actions in July may wind up offsetting some of the potential damage of a negative quarter, like they did in 2013. That isn't going to be a long-term fix, but it does indicate the potential for quick rebounds off support if prices come off their highs.
Bottom Line – Flat Trading Before Labor Report
This is a shortened week, and trading is usually pretty quiet before and just after the Fourth of July holiday. The labor report for the month of June will be released on Friday, which could produce some volatility before the weekend. However, I expect that the market will really start to move one direction or the other as investors prepare for the bank reports to start streaming in at the end of next week.
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