Bullish Consolidations Form, Banks Perk Up, Yields Spreads Narrow and Fed Balance Sheet hits New High

Stocks remain strong overall with small-caps starting to outperform. Moreover, the small-cap ETFs worked off their short-term overbought conditions with bullish continuation patterns. Not to be totally left behind, SPY and QQQ also formed short-term bullish continuation patterns.

Even though the flags shown below are short-term in nature, the bigger remains bullish for stocks and the path of least resistance is up. In addition to recent leadership in small-caps, we are also seeing banks start to lead. While I do not know if this is related to the recent narrowing of the BBB and CCC spreads, it certainly doesn’t hurt that the bond market is showing more confidence.

Note that I will post an update for the breadth models later this morning.

SPY and QQQ Form Bullish Consolidations

The first charts show the S&P 500 SPDR (SPY) and Nasdaq 100 ETF (QQQ) with wedge breakouts on September 28th, follow through until October 12th and falling flag patterns taking shape. The falling flag, wedge or pennant is a short-term bullish continuation pattern and a breakout would argue for a move to new highs.

Long-term, SPY and QQQ hit new highs in early September and remain well above their rising 200-day SMAs. The long-term trends are clearly up and this favors further gains because the long-term uptrend is the dominant force at work.

Note that short-term bullish continuation patterns can take a number of shapes. Typically, they run two to four weeks and form falling flags or wedges. We can also see pennants and small triangles take shape, which are pretty much the same pattern. All of these represent a rest after an advance and this is the pause that refreshes. Breakouts signal a continuation higher.

Average Stock Starts to Lead

Equal-weights, mid-caps and small-caps (average Joe stocks) started outperforming with surges that started on September 25th, when they were near their 200-day SMAs. The charts below show the S&P 500 EW ETF (RSP), S&P MidCap 400 SPDR (MDY), S&P SmallCap 600 SPDR (IJR) and Russell 2000 ETF (IWM) exceeding their August-September highs with double digit surges from September 25th to October 12th. All four edged lower after these surges to work off overbought conditions. Falling flags formed and all four surged on Thursday. The bigger trends are up and the falling flag is a bullish continuation pattern. As such a breakout would signal a continuation higher and open the door to new highs.

Note that trading falling flags can be tricky, especially short-term falling flags that are rather tight, like these. The chart above shows IWM with a flag breakout in late August and then a decline to the 200-day SMA. This flag breakout did not work. Not all flag breakouts work. I don’t know if this one will be different, but I do know that small-caps are starting to lead and this bodes well for follow through after the breakouts. A move back below the flag low would be short-term negative, but this would not affect the longer term uptrend.

IWM:SPY Ratio Challenges Early June High

The next chart shows the IWM:SPY ratio hitting a multi-year low in early April, surging into early June, consolidating into early October and surging the last three weeks. The ratio broke above the 200-day for the first time since September 2018 and a break above the early June high (red line) would show further outperformance.  

Banks Power Small-caps

According to the iShares website, the Financials sector is the second biggest sector in the S&P SmallCap 600 SPDR (17.08%) and the Russell 2000 ETF (15.42%). ETFs like the EW Finance ETF (RYF) and Regional Bank ETF (KRE) are dominated by small-caps and mid-caps, and hold valuable clues for the two small-cap ETFs. I featured KRE in yesterday’s commentary, but had a brain fart and left out the commentary paragraph. Yesterday’s commentary has since been updated and I will update again here.

The chart below shows KRE surging from September 25th to October 12th and breaking the upper line of a falling wedge. Note that this falling wedge retraced around 2/3 of the prior advance and held well above the March low. KRE went from long-term laggard on September 24th to short-term leader with a break above the 200-day on Thursday. A small bull flag formed prior to this breakout and KRE is now challenging its August high. Given the wedge and flag breakouts, I would expect KRE to exceed this high and challenge the early June high. Also notice that StochClose turned bullish with a move above 60.

The next chart shows the Finance SPDR (XLF) with the three breadth indicators. Two of the three are on active bullish signals and the sector has been net bullish since October 7th. XLF edged above its 200-day on October 12th, fell back with a small flag and surged 2% on Thursday.

Yield Spreads and Fed Balance Sheet

Yield spreads remain narrow and show little stress in the credit markets. The lower window on the first chart shows the BBB spreads continuing to narrow and hitting their lowest level of the cycle, which began in mid March. BBB bonds are the lowest rated investment grade bonds and further narrowing of the spreads is positive for stocks.

CCC bonds are the lowest rated of the junk bonds and their spreads narrowed further this week. This narrowing means bond pundits demanded less premium over Treasuries, which is a sign of confidence.  This also suggests a positive outlook on the economy and fewer defaults.

The Fed balance sheet continued to edge higher with another $26 billion increase. Total assets on the Fed’s balance sheet exceeded the mid June high and this is a new high. For whatever reason, the Fed continues to supply cool-aid to the markets.

Thanks for tuning in and have a great day!

-Arthur Hill, CMT
Choose a Strategy, Develop a Plan and Follow a Process

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