Junk Bond Spreads Widen, Small and Micro Caps Underperform, Energy Related ETFs Fail to Bounce (Premium)

Today’s commentary will look at the recent widening in Junk bond spreads because this widening shows less confidence in corporate bonds with the highest risk. We are also seeing some risk aversion in the stock market because small-caps are lagging large-caps. Small-caps represent higher beta stocks, which are considered riskier than large-cap stocks. I am also seeing some bearish patterns in the energy-related ETFs because they failed to bounce the last few weeks.

Junk Bonds Widen from Low Levels

I noted in Friday’s Market Regime update that the Junk bond spreads and CCC bond spreads were widening since early July. CCC bonds are the lowest rated junk bonds and represent the highest credit risk in the bond market. The CCC spread widened from 5.8 to 6.6 from early July to mid August. Even though 6.6 is still low on a historical basis, the widening shows a little less confidence at the junk end of the bond market. I am not seeing levels or a sharp widening that would suggest a bear market, but the slow widening since early July could be weighing on small-caps and could foreshadow a correction in the stock market.

The CCC spread is the difference between the yield on CCC bonds (high risk) and US Treasury bonds (safe haven). A narrowing of this spread shows confidence in the bond market because this means bond investors are demand less premium over Treasury bonds. A widening shows less confidence because it means investors are demanding a higher premium (over Treasuries) to hold higher risk bonds.

Small-cap Growth and Value Lag

The next chart shows three growth-value pairs. Large-cap growth and value are leading, while small-cap growth and value are lagging. This performance chart shows the S&P 500 Growth ETF (IVW) leading the pack since March with a 17.5% gain. The S&P 500 Value ETF (IVE) is also performing well with an 11.3% gain. The S&P 400 MidCap Value ETF (IJJ) is up around 9.2%. The S&P 400 MidCap Growth ETF (IJK) and Russell 2000 Value ETF (IWN) are up 3-4%, but lagging the others. The Russell 2000 Growth ETF (IWO) is by far the weakest link with a 7.3% decline since March.

IWM and IWC Form Short-term Bearish Patterns

The next chart shows the Russell 2000 ETF (IWM) with a long-term bullish pattern, but a big trading range and short-term bearish pattern. The chart in the upper left shows a possible bull flag, which is a bullish continuation pattern and a breakout would be bullish. The bar chart expands on the trading range and we can see that the swing within this range is up. So far so good, but…

The candlestick chart shows a bearish wedge hitting resistance in the 50-67% retracement zone. A counter-trend bounce typically retraces one to two thirds of the prior decline and the rising wedge is a bearish continuation pattern. Also note that momentum resistance is nigh as RSI stalls in the 50-60 zone (blue shading). Thus, we have a short-term bearish setup in IWM and a break below 217 would argue for a break below the March-July lows.

The next chart shows the Russell Microcap ETF (IWC), which is even weaker than IWM. The long-term charts look the same, but the recent bounce in IWC was weaker because the ETF did not exceed its July 21st high. This looks like a sharp decline from mid June to mid July and then a short-term consolidation, which is a bearish continuation pattern. A pattern break would argue for further weakness below the March-May lows.

Oil Battles Support

I covered oil on Friday and will revisit this chart before looking at the energy ETFs. I took off the rising channel because long angled trendlines are very subjective and not that reliable. I use trendlines to draw patterns, such as triangles, wedges, flags etc… The bar chart shows spot crude testing support from broken resistance in July and August. RSI is also bouncing in the oversold zone (around 40). Thus, there is a short-term mean-reversion setup on oil. The candlestick chart shows the US Oil Fund (USO) with a reversal around the 67% retracement line, but no follow through. A break above the red resistance line would show follow through and complete the reversal.

Energy ETFs Form Short-term Bearish Patterns

The energy-related ETFs are looking bearish because RSI(14) dipped below 30 in mid July and these ETFs did not bounce with the rest of the market the last few weeks. A move above 70 in RSI(14) shows strong upside momentum and this is bullish. On the Oil & Gas Equipment & Services ETF (XES) chart below, notice how RSI exceeded 70 from November to June as the uptrend in XES extended. The plunge below 30 shows strong downside momentum that could also signal a trend reversal. RSI typically bottoms in the 40 area during an uptrend and a move below 30 shows exceptionally strong downside momentum.

On the bar chart, XES formed a pennant just above the 200-day and broke pennant support with a sharp decline in early August. This signals a continuation lower and argues for a break of the April low. Note that XES is the weakest of the three energy-related ETFs because it is below its 200-day.

The next chart shows the Oil & Gas Exploration & Production ETF (XOP) with similar characteristics. There was NO follow through to the island reversal and a bearish pennant formed the last few weeks. I would expect a continuation lower and re-evaluate on a close above 84 or with a breakout in USO.

The next chart shows the Natural Gas ETF (FCG) with similar characteristics. FCG is a little stronger than XES and XOP because it held well above the April low and StochClose did not trigger bearish. StochClose triggered bearish for XES in late July and for XOP in late August. Energy is not the place to be right now.

The image below shows the most recent StochClose signals. XOP and XES are highlighted in blue.

Thanks for tuning in and have a great weekend!

-Arthur Hill, CMT
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