Perspectives

TSP Charts: Are small caps signaling a larger correction

We witnessed a ripple effect across many asset classes last week. The last week of April saw a reversal of many “crowded” trades to include European bonds, the US dollar and small cap stocks that had run-up significantly prior to the reversal.   But looking at the charts of the TSP S and C funds, my thoughts were that we have seen this before and the outcome was not good.

Let’s look at two previous periods were we saw divergence in the performance of the TSP C fund (large cap S&P 500 companies) and TSP S fund (rest of the US market small and mid cap companies).

Previous Divergence in funds

Previous Divergence in funds

In the chart above we see the small cap TSP S fund peak and decline while the TSP C fund posted a new high before correcting.  We also saw this occur in November prior to a five percent correction in the C fund, so this does not make the current picture comforting.

1 May 2015

1 May 2015

As you see in the next chart the dollar has been strengthening against the EURO since last spring (indicated by a declining EURUSD).  I circled the two days when a higher-low in the EURUSD occurred and we see the short term trend reversed.  These dates correspond to the two recent market peaks in the TSP S fund (blue line in chart above).   The TSP S fund had been outperforming the TSP C fund due to the dollar’s strength and its negative impact on the large companies of the S&P 500 earnings.  The reversal in the dollar caused a reversal in investors expectations of large cap earnings and relative strength shifted back sharply to the TSP C fund last week.

US Dollar Weakened Last Week

US Dollar Weakened Last Week

So why did the dollar reverse last week?  The official results of the 1st quarter GDP in the US was released and the world learned we only grew at a 0.2% pace as I have been reporting for the last month.  This impacted the market expectations in two ways.  First the market again believes the Fed will not raise rates any time soon which had been supportive of a stronger dollar.  Second, until this report everyone believed the US economy was much stronger and this supported the markets in the US.

The markets were also affected recently by two well-respected bond traders calling the German bund (bond) the short of the century.  This is very much like telling the emperor he has no clothes.  With the ECB forcing interest rates negative with their QE program, these well-followed bond traders simply pointed out that the only direction for bond prices is down.  Hold bonds with negative yields you lose money on yield.  If the yield rises, you lose more on the declining bond price.  The Euro bond yields spiked higher on these comments and again this rippled across the markets.

I believe the weakening dollar supported the larger cap stocks last week preventing it from correcting with the small cap indexes.  But the S&P 500 index’ (TSP C fund) price has diverged from market internals and typically price catches up with internals.  We are also entering the weak season for equities and May does not have the best track record.  The rippling effects across many assets classes may be the beginnings of a shift to a more risk averse market and caution is warranted.