Monday, April 19, 2010

ETF Pairs as Sentiment Gauges: EEM and SPY

I recently took at look at ETF pairs--consumer discretionary and consumer staples issues--as sentiment gauges for the broad stock market. Above we see another ETF pair: emerging market stocks (EEM) vs. U.S. large caps (SPY) as another gauge of speculative sentiment in the stock market.

EEM represents trader and investor interest in the fastest growing economies in the world. While these display high potential appreciation, they are also quite vulnerable to downturns in global economic strength. SPY represents a universe of shares with lower growth potential, but also higher stability.

When traders and investors anticipate strong global economic growth, they will tend to favor more speculative, growth-oriented regions of the world. That will show up as EEM outperforming SPY. When traders are more risk averse and anticipating global slowdown, they will tend to seek the relative safety of large cap stocks in the world's largest economy. That will show up as SPY outperforming EEM.

What we've seen lately (above) is that, despite very rapid economic growth in Asia and South America, EEM has stopped outperforming SPY. Early in the bull market, we saw EEM dramatically outperform SPY. Since the fourth quarter of 2009, however, that outperformance has stopped.

This leads me to believe that traders and investors are anticipating a monetary tightening cycle among emerging market central banks, restraining growth potential. To the degree that economies in the U.S. and Europe are looking to exports to emerging market economies to fuel their own growth, we could see some headwinds going forward. I will be watching this theme closely, as it could lead to a more challenging environment for all stock markets as the year progresses.