I wanted to use this blog entry as an opportunity to introduce some interesting technical work by a fellow who I sponsored for the Chartered Market Technician designation (CMT). Boris Chai recently sent me this chart noting the relationship between US utilities and long bonds. In a nutshell, Boris shows that the ratio of utilities to bonds troughed and signalled a move towards a new bear market in both 2000 and 2007. While it’s a relatively small data sample, the recent move by investors out of utilities and into the long bond provides some evidence of more pain to come for the markets. So, we should bear this in mind, as a balancing indicator vs. the more upbeat leading indicator research I presented in my blog last week here.
Here is Boris’ writeup on his ratio chart:
“The $USB and $UTIL ratio explains the transition of a risk off market to a risk-on market by analyzing their relative performance. It is easy to understand that the utilities sector is the one of the most conservative and defensive sector in the market. This sector is heavily invested by retirees and dividend generated mutual funds. The dividend from utilities sector is very predictable. During a bull market, utility stocks may or may not outperform the market. However, when you look into the dividend growth model, the growth of the dividend always add incremental return when we compare to the long term bonds. In a bull market, the utilities stocks should outperform the Long term 30 years US treasury bond. This inter-market relationship should change when the market seeks safe haven by selling the most defensive sector and moving the assets into 30 years US treasury bond. The reason is that investors feel that even the most defensive sector (utilities) is no longer safe. The rotation into long term bonds is the last signal for the market to tell you we are going into very risky territory. You can see this transition happened in the last 2 bear markets. The blue line and the circle marked this transition. They have a very similar pattern.”