In the first few days of the fourth quarter of 2018 there have been two major themes. First is a very large disparity between performance of the DJIA and the broad market. Over the last three days the Russell 2000 ETF (IWM) has declined 1.5% while the DJIA has increased 1.4%. In addition, breadth has been poor and there has consistently been more stocks hitting new lows than new highs.
The second theme that has developed is a breakdown in bonds to the lowest level in years. The iShares 20+ Year Treasury Bond ETF (TLT) broke a major support level yesterday and traded down to levels it last hit back in 2015. TLT is gapping down further this morning and is now back to where it was in September 2014.
These two themes are both products of changes in allocations by major funds. After the third quarter closed there was a move out of smaller stocks and into a handful of bigger cap names. Outperformance by a narrow group of big caps has made it difficult for some major funds to beat their benchmark indices. This allocation move is likely a response to that. It would appear to be a late reaction to damage that has already occurred but that isn't unusual when large funds are trying to make up ground.
This inconsistency in action between large and small caps is flashing some warning signs but so far the theme hasn't developed far enough to cause a major change in market character. However, when it is considered in combination with this spike in interest rates there is a good case for increased caution.
The bears have long argued that higher interest rates would eventually kill this uptrend. They have been arguing that point for so long that it has become meaningless. The theory that when the Fed started unwinding its accommodative policy it would cause major problems has proven incorrect for so long it has lost its potency.
What the bears have overlooked is that that market can handle higher rates if there is good economic growth. Economic growth has picked up steam lately and that has allowed market players to shrug off a more hawkish Fed. If there were signs of an impending recession or an economic slowdown then these higher rates would likely have a much greater market impact.
It is extremely important to keep in mind that small changes in interest rates tend to cause massive shifts in capital. It doesn't take much of a change in rates to trigger big moves and when bonds break a significant technical level some of the flows are automatic.
Higher interest rates will cause increased competition with equities which is why the breakdown in bonds is a negative for the market. However in the shorter term the money coming out of bonds may be parked in 'safe' equities which may be part of what is driving the DJIA to outperform. Big cap names are typically less sensitive to interest rates than small caps and that may be part of the reason that the rotation is taking place.
This market is very messy and chaotic right now as it wrestles with both bonds and massive reallocations. There is still some good stock picking such as Lilly (LLY) , but it is very narrow. This is a market driven by macro matters and is not as favorable to stock pickers right now.
We have a soft open as bonds continue to break down but there are some signs of dip buyers.