It’s time to do a technical checkup on the market. There have been a couple of trends to note recently that indicate where investors should bias their equity allocation. As I have mentioned a few times lately, there has been a large concern over valuations in the market. The general consensus right now is that large-cap and value stocks are cheaper relative to growth and small-cap. The shift in sentiment has continued since March despite the recent rally in all areas – and we can see it in the charts.
In March and April, growth stocks were hit hard. Investors weren’t going into cash, however, but into value stocks, which is why the broad market went sideways. Below is a relative strength chart that plots growth stocks in the numerator and value stocks in the denominator for the S&P 500. A falling line indicates better performance in value and a rising line indicates better performance in growth. The recent rise in the S&P was mainly a result of the rally in growth stocks that were hit in March and April which is indicated in the chart below; however, many of those momentum stocks have failed to return to their March highs.
Performance has been better in large-cap versus small-cap for much of the same reasons I expressed for growth versus value. Investors have been nervous about valuations, geopolitical risks, and the economy given the first quarter slow down on weather and inventory draw downs. Small-cap stocks were extended after the first quarter, and then sentiment shifted. Despite the sizeable rally in the Nasdaq Composite and in the Russell 2000 recently, the S&P and the Dow Jones Industrial average have performed the best in Q2.
While the S&P 500, the Down Industrial Average, and the Nasdaq Composite have been treated to new highs in July, the Russell 2000 was rebuffed by its highs and has experienced a volatile swing lower. The index broke short-term support on July 10th and could not get back above it in the following couple of days. Support now is between 1082 and 1100. The Russell 2000 is in full correction mode. It will be interesting to see whether the index can rally back above the 200-day moving average or test its May low.
There was a lot of criticism of equities during April and March due to the correction in growth and small-cap. It was declared that the 10% correction was finally upon us. We’ve had a 10% correction in the Russell 2000 in just the last few weeks. I cautioned investors that it is important when investors shed riskier asset; however, if the rotation is into value and large-cap stocks and not cash, then we’re simply experiencing rotation and not deleveraging. It’s interesting to note that the Russell 2000 only represents 8% of the overall Russell 3000 market cap. I caution investors and analysts from putting too much emphasis on 8% of the market as a proxy for the whole.
Breakdown of the Indices
As of right now, the S&P 500, the Dow Industrial Average, and the Nasdaq Composite are in much better technical shape. They have had a nice run in June and may be due for a short-term correction, especially as we get into seasonal patterns that typically show weakness. Below is a seasonal chart of the S&P 500 over the last twenty years. It shows flat average returns between May and July and then turns negative in August and September.
Here are some notes on the S&P 500 and the Dow Industrial Average. Both are in excellent technical shape with a pinch of weakness short-term. The Dow has shown some churning here while momentum gets worked off, but the overall accelerated trend is acting as strong support to that churn. If the trend breaks, there is the possibility we retest the 16,600 breakout. Retests are healthy and don’t negate the breakout - they confirm them.
The S&P 500 registered a MACD sell signal on July 8th and has been falling as the index consolidates. This doesn’t indicate a trend reversal, however, and could merely mean the index is in store for a sideways consolidation. Momentum shows the same thing with an overbought reading above 70 on July 3rd, which has now settled down near neutral on the RSI indicator. Right now, the S&P 500 index failed to break to new highs on Wednesday and experienced a harsh sell off today, down 1.18% to 1958. The index is currently sitting on short and intermediate-term support. If the support breaks, a short-term top will have been completed and the next support is a test of the 50-day moving average, which is at 1934 today. Today’s selloff erased gains made over the last four days with a bearish candle pattern.
So seasonality and momentum indicators suggest a consolidation is here. Today, supports were tested. If they break, we’ll be treated to a short-term correction with plenty of significant support nearby. We’ll have to review the market again if those supports hold or break. Today’s losses have erased the last four days of gains, which is typically a bearish situation. Tomorrow will be an important day for equities – technically speaking.
To add some perspective, the S&P was trading near the top of the channel for the current bull market. Usually, that’s an indication of strength. Most tops are typically formed when a market trend fails to reach the upper channel; however, it does open up the possibility of a bull market consolidation or worse, a bull market correction. The 2013-2014 trend has been a strong one despite two major consolidations (May 2013 to September 2013 – taper tantrum and January 2014 to May 2014 – winter growth scare). Too many 10% correction forecasts by technicians have been false over the past two years. Let’s wait until the trend breaks before sizing up the downside risk. Now that we’ve reached the upper channel of this bull market, the chances have risen, but I’ll let the market do the talking from here.
