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Market Timing Model – Small-caps Soften as Large-caps Hold Strong

The sky is falling as the S&P 500 fell a whopping .5% the last four days.  Small-caps and mid-caps were hammered as the S&P SmallCap 600 SPDR fell 1% so far this week and the S&P MidCap 400 SPDR declined 1.3%. I am sure that there are probably some good reasons for these minuscule moves. Heck, there are always reasons.

In all seriousness, we cannot make much out of small declines that follow huge advances. In addition, we should avoid, at all cost, attributing short-term movements to news events. News is noise and nobody really knows why stocks rise or fall. Actually, I do. Stocks rise when buying pressure is stronger than selling pressure, and fall when selling pressure is stronger than buying pressure. It’s that simple.

Our job as chartists is to put these price movements into perspective (sans news). Stocks surged from early October to early November with small-caps leading the charge. Note that the S&P SmallCap 600 SPDR (IJR) and Russell 2000 ETF (IWM) were up around 8.5% from October 8th to November 4th. A corrective phase after such a surge is pretty normal. The chart below shows MDY correcting with a flat flag, while IJR and IWM correct with falling flags.

Also keep in mind that SPY and QQQ hit new all time highs in November and are leading on the price charts. MDY also hit a new 52-week high, but remains short of its September 2018 high (~3.5%). Drilling down into the equal-weight universe, we can see that the S&P 500 EW ETF (RSP), EW Industrials ETF (RGI), EW Technology ETF (RYT), EW Healthcare ETF (RYH), EW Finance ETF (RYF) and EW Consumer Staples ETF (RHS) hit new highs in November. These new highs show broad strength, or at least broad enough.

New highs are bullish and we are seeing new highs in several key sectors. Relative weakness in Consumer Discretionary is a concern, but not reason enough to turn bearish on the stock market. It is, perhaps, reason enough to avoid XLY and XRT.

Defining the Long-term Trend

The weekly chart below shows SPY breaking out of a large Symmetrical Triangle to signal a continuation of the bigger uptrend. The long-term evidence is unequivocally bullish: price is above the rising 40-week EMA, the PPO(4,40,0) is positive and price hit a new high. The index stalled this week and an indecisive candlestick is forming. I am not going to read too much into this week’s candle because the chart is littered with small indecisive candles. Some foreshadowed pullbacks, and some didn’t. Don’t forget to look at past instances before making assumptions on a current instance.

Defining the Short-term Uptrend

IJR and IWM are currently pulling back, but SPY and QQQ remain quite strong. The chart below shows the S&P 500 with the 1-day ROC and the 2-day ATR. The green zones show when the ROC(1) and ATR(2) reflected low volatility to support a short-term uptrend. The red lines show when ROC (1) exceeded -1% and ATR(2) exceeded 30. We are currently in a low volatility advance and I would not expect a pullback until ROC(1) moves below -1% and ATR(2) moves above 30.

I focus mostly on the S&P 500 because the broader market is likely to correct if the S&P 500 pulls back. Moreover, small-caps and mid-caps have a greater chance of ending their corrections sooner as long as the S&P 500 remains short-term bullish. Should the S&P 500 indicator signal a pullback, I would then target the 3000-3025 area for support. The rising 50-day SMA, 38-50% retracement zone and broken resistance mark support here.

Index Breadth Model Remains Firmly Bullish

The Index Breadth Model remains firmly bullish with eight of the nine indicators on active bullish signals and the majority on active bullish signals since September 5th. Even though S&P 600 SmallCap High-Low% ($SMLHLP) perked up in late October and early November, the indicator fell short of triggering a bullish signal with a move above +10%. Small-caps remain the laggards when it comes to internal leadership (new highs).

High-Low Lines Still Rising

Despite uninspiring High-Low Percent, new highs continue to outpace new lows and the High-Low Lines are still rising (above their 10-day EMAs). As the chart below shows, two of the three High-Low Lines have been above their 10-day EMA since early September. The bulls have the edge until two of the three turn down.

Sector Breadth Model Remains Strong

The Sector Breadth Model remains firmly bullish with ten of eleven sectors net bullish and 30 of 33 indicators on active bullish signals. Most importantly, all five offensive sectors are bullish and the second largest sector is bullish (XLV). There is one new signal in the Sector Breadth Model as the 10-day EMA of XLE AD Percent ($XLEADP) moved below -30% on Tuesday. XLE has been net bearish since May and now all three breadth indicators are on bearish signals.

Consumer Discretionary Underperforms

The chart below shows the percentage of stocks above the 20-day EMA for the six biggest sectors in the S&P 500. This breadth indicator is used to compare short-term performance and the Consumer Discretionary sector is lagging the other six. XLY %Above 20-day EMA (!GT20XLY) moved below 50% this week and is the only one below 50%. XLV %Above 20-day EMA (!GT20XLV) and XLF %Above 20-day EMA (!GT20XLF) are holding up the best and above 80%.

The next chart shows the percentage of stocks above the 200-day EMA for the same sectors. Again, Consumer Discretionary is the weakest of the six with XLY %Above 200-day EMA (!GT200XLY) at 56%. The other five are above 65%. Technology is at 79.40%, while Finance, Industrials and Healthcare are above 85%. Even though Consumer Discretionary is lagging, we are seeing broad strength within four of the six big sectors and this is bullish for the S&P 500.

Balance Sheet Contracts as SOMA Expands

Total assets on the Fed balance sheet [1] contracted, but the System Open Market Account (SOMA) [2]¬†increased. Note that SOMA is the largest part of the Fed’s balance sheet. An increase in SOMA suggests that the Fed is buying securities in the open market. This means the Fed is putting money into the market and this is net positive for the stocks. Keep in mind that the Fed’s balance sheet and SOMA are just two indicators and I take a weight of the evidence approach. I would never base a bullish or bearish stance on just the Fed.

Bottom Line: Bull Market Environment

There are still pockets of weakness in the stock market, but there are fewer pockets of weakness now than two months ago. Small-caps are perking up as IJR and IWM exceeded their September highs and forged higher highs in November. Even so, small-caps are still laggards when looking out 3, 6 and 9 months.

Within the large-cap world, participation is clearly broadening with several key sectors hitting new highs. We are also seeing a revival within the Technology sectors as the Software ETF, FinTech ETF, Cyber Security ETF, Cloud Computing ETF and Cyber Security ETF broke out over the last few weeks.

Determining the broad market environment is more than half the battle, and we are in a bull market environment. Trade accordingly. This means long positions are preferred over short positions, bullish setups are preferred over bearish setups and bullish resolutions are more likely than bearish resolutions. The cup is more than half full.

That's all for today. Thanks for tuning in!