Several indicators we track reversed to the positive over the last week. Is it time to jump back into equities, some think so, but we prefer to watch a little longer in this rapidly oscillating market. One of the measures of risk aversion we have been watching is looking better this week, but has not broken its long term trend yet.
Since June 2014, credit spreads have been widening and this usually occurs months before large corrections or market tops. As you can see, its more recent and steeper trend (red) broke down this week, but it remains above its longer term upward trend. When looking for other indicators that correlate to the credit spread we find that the price of crude oil also began its long slide in June and this week it had a solid bounce higher making many believe the bottom was in. With crude oil inventories still rising this trend could reverse lower again. But credit spreads are not the only signal to reverse this week, we also see that market internals appeared to improve this week.
While the 8 and 22 January peaks were basically identical in price the Bullish Percent Index declined (red lines). During the latest peak on Thursday the Bullish Percent Index turned back up. We were watching for a higher close on the S&P 500 on Friday, but the index bounced off over-head resistance (gray line). Since Thursday’s Bullish Index is still below the 8 January Bullish Index this market internal has us waiting also. The S&P 500 (TSP C fund) is still 1.5% off its all time high. The TSP S fund did break out to a marginal new high and has a more bullish upward trending chart as seen in blue in the following chart. Note the rising lows for the TSP S fund. Mid-caps have been performing better than small caps within the S fund.
Another indication that this last week was a risk-on week, was the performance of the equity funds over the F fund. While the equity funds were oscillating in January, the F fund rose but this dynamic reversed in February. The F fund’s price movement is directly related to interest rates, but investors shifting funds out of equities and into fixed income funds has a short term effect on rates. As interest rates have declined globally, the F fund has seen its underlying securities appreciate in value. This week interest rates reversed and headed higher resulting in the F fund giving back some of its capital gains.
I recently discussed the end game of the bond market’s bull market and the F fund’s future returns. The fund’s underlying securities have an average duration of 5 years so for every one percent move in interest rates the price of the fund moves 5% the opposite direction. The F fund has approximately a 2% yield today and we can easily calculate future F fund returns if we knew the future direction of interest rates. There are strong arguments from all sides on what interest rates are going to do going forward. Some are arguing they can go below 1% in the US. But it is important for investors to know that interest rates are at historical lows globally and global central banks are continuing to push them lower. The exception is the US Federal Reserve which is talking about raising Fed fund rates in June.
Quick math on possible outcomes: A) Interest rates drop by 1%, bringing the TSP F fund yield below 1% during the next year: (1.5% average yield + 5% price appreciation = 6.5% return in 2015 with a measly 1% yield going forward). B) Interest rates stay near 2% (2% yield plus 0% price gain= 2% return) C) Interest rates rise 1% (2.5% average yield – 5% price = -2.5% loss and a 3% yield going forward). A simple half a percent gain in interest rates this year would zero out the F fund’s return this year. As you can see, the timing of when interest rates reverse their 26 year bull market matters to the F fund, but the losses would be manageable. The effect on the equity funds might not be so kind.
If the indexes can convincingly break out of their sideways channel while measures of risk aversion remain subdued and market internals are supportive, then a shift to more exposure to equities until the strong season in equities ends might be a good risk-adjusted move. These conditions do not change the fact that the markets are significantly over-valued and the long-term return on the equity funds is low. But the market has our interest, we are still waiting. Next week could be telling.
Categories: TSP Charts