Over the last couple of weeks, equities have decidedly taken the backseat in setting the pace for global asset markets. Indeed, cues for directional moves were to be taken from the commodities space during the period. As over-leveraged positions in futures markets were initially pricked by higher margin requirements from exchanges, the sandcastle started to collapse.
Is it a sign of an upcoming economic slowdown? Maybe, but we are not convinced, since it appears very much like the crowded space of relatively small raw commodity markets have set up a global (and probably short-term) de-leveraging exercise. As highly leveraged funds struggled to face mounting margin calls, equities were never going to be left untouched.
For all the talk about the correlation between the commodity asset class and equity markets, the slide in commodity prices does not seem to provide a strong leading indicator for what’s in store for equities.
Indeed, the long or short term correlation (even when using lags) is pretty poor with for example a long term correlation of 0.4 as shown in the chart below:
Correlation of weekly returns between CRB/Reuters commodity index and S&P500 – source Bloomberg
In fact, the commodity sector has underperformed the general market since the beginning of the year, even before the recent sell-off. Indeed, the following chart illustrates that up to May 1, i.e. before the commodity rout, the Basic Resources sector was already the worst-performing sector of the broader Euro Stoxx 600 index at that point in time:
Year to May 1 returns by sectors – source: Bloomberg
Hence the current sell-off in commodities may indeed be misleading for the general direction of equity markets!
Of course, the ongoing talks about the necessary short-term restructuring of Greek debt has added to the general market nervousness. This would amount to opening a Pandora’s box both for the European and Central European banking systems. We do not believe that the European Union and the International Monetary Fund feel ready for this exercise just yet. Hence we firmly believe that the can will be once again kicked further down the road at the end of the joint EU/IMF visit this week.
When looking at the fundamental drivers of equity markets, we still focus on the fact that equities remain a relatively attractive investment proposition for a world awash with liquidity. Indeed, against a still benign inflation background, the S&P 500 still offers an earnings yield of 7.30% for the full year 2011 versus “risk-free” U.S. two-year government yields of 0.54% and 10-year of 3.2%.
What’s more, the U.S. yield curve does not offer the prospects of an impending recession in the biggest world economy:
USD Yield curve – source Bloomberg
The yield curve in Europe provides an even cleaner half-bell shaped curve pointing to the same state of play.
All in all, however, the recent rout in commodity prices has certainly put equity investors on the run in the short term. When looking at the Bull-Bear ratio, we see that the number of bears has suddenly started to outstrip the number of bulls, and this only for the second time this year (the last time was due after the Japanese earthquake):
AAII Bull Bear Index – source: Bloomberg
We are getting again close to a position where equity investors may becoming overly bearish. Hence, we caution against this commodity-led “run for the hills” in the equity space!
From a technical perspective, important supports are still intact.
Looking at the S&P 500, it appears that support at 1,330 remains intact despite the onslaught of the past week. We are still clearly in a consolidation phase in a triangle formation. We also find that the longer term uptrend remains intact.
S&P 500 – Daily chart – source: Bloomberg
We therefore urge our clients to continue respecting the longer term trend, keeping in mind that only the break of 1,330 could herald a sharper sell-off towards 1,300. To the upside, we look for a test of the 1,380 level next week.
For the Euro Stoxx 50, the picture remains the same. The rejection of the 2,900 support area is significant and should provide the fuel for more upside in the coming week, possibly on the back of a new EU/IMF Greek package to be announced shortly.
Euro Stoxx 50 – Daily chart – source: Bloomberg
We will therefore be looking for a break of the 3,000 level in the coming week with a target of 3,020 for the week.
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