Major index ETFs Become Short-term Oversold, Three Medium-term Issues to Watch going Forward (Premium)

Stocks were hit pretty hard the last few weeks with small-caps leading the way. The recent outsized declines created short-term oversold conditions that could lead to a mean-reversion bounce in the coming days. However, there are some medium-term issues that point to a corrective period in the coming weeks. Namely, the advance continues to narrow as breadth deteriorates. We are entering a seasonally weak period and two ratios point to risk aversion in the markets. Keep in mind that correlations rise when the S&P 500 corrects and this means most equity-related ETFs will follow the S&P 500.  

This is a broad market update to address some recent developments. I also updated the ETF Ranking, Signals and Setups Table because there are new trend signals in IWM (bearish) and TLT (bullish). See link at top. The next update will be Thursday.

SPY Tests 50-day Yet Again

SPY, which represents large-caps and large-cap techs, continues to grind higher since the November breakout. Short-term, the ETF fell over 2% the last three days and this is the fifth 2+ percent decline since the November breakout. The lowest chart window shows the 3-day Rate-of-Change with the gray line at -2%. RSI also dipped into the oversold zone (turned blue) and SPY tagged its 50-day SMA (green dashed line) for at least the sixth time. Once again, SPY has a short-term oversold setup working within a long-term uptrend.  

The next chart shows SPY in the main window, RSI and the 5/200 price oscillator. The green shading shows when RSI is oversold (between 30 and 50) and the 5-day SMA is above the 200-day SMA (5/200 price oscillator is green). 1 day oversold bounces are rare, as are oversold bounces after just a few days of oversold conditions. Thus, we are more likely to see oversold conditions last one to four weeks before we get an oversold bounce.

QQQ Triggers ATR Trailing Stop

QQQ, the Technology SPDR (XLK) and several tech-related ETFs surged from mid May to mid July with market-leading advances. They fell sharply the last three days and many triggered their ATR Trailing Stops, which were in place since the mid May breakouts. Short-term, these ETFs are now in the trend-monitoring phase as we wait for the next setups. Long-term, the trends are clearly up with QQQ and XLK hitting new highs in July. The chart below shows QQQ surging some 15% in nine weeks and RSI hitting 77 on July 7th. The ETF fell sharply and triggered the ATR Trailing Stop (red line). A pullback to the rising 50-day SMA (green dashed line) could lead to the next short-term bullish setup.

You can learn more about ATR Trailing stops in this post,
which includes a video and charting option for everyone.

Equal-weights and Small-caps Oversold

The cup is still half full for SPY (bullish), but less so when we move down in market cap: equal-weight, mid-caps and small-caps. The chart below shows the S&P 500 EW ETF (RSP), which basically removes the influence of large-caps and focuses on performance for the average stock in the S&P 500. SPY hit new highs in June and July, but RSP traded flat and did not confirm (blue shading). The big trend is still up and this consolidation is still viewed as a consolidation within that uptrend.

Short-term, RSP gapped down on Monday and fell to its May-June lows, but not all down gaps are bearish. Note how RSP gapped down on January 27th and got an oversold bounce off the rising 50-day SMA (red shading). The bottom window shows the 5-day Rate-of-Change dipping below -3% for the fourth time since the November breakout. RSI is also quite oversold with a dip to the 35 area. While the stage is set for a short-term mean-reversion bounce, I am less convinced that this will lead to a bigger breakout and end to the correction. More on this topic in the next segment.  

The next chart shows the Russell 2000 ETF (IWM) with a sideways correction since mid February (100+ days). The blue shading shows where IWM bounced in March and May. The ETF is trading in the blue zone now and near the rising 200-day. RSI dipped below 30 on Monday and the 11-day Rate-of-Change is below 7% for the third time since March. IWM is also short-term oversold and ripe for a mean-reversion bounce.  

Three Items Pointing to a Correction

The S&P 500 is overdue for a correction, but overdue does not help much with timing. Medium-term, breadth continues to deteriorate, seasonal patterns are very weak in August-September and junk bonds are seriously underperforming.

The first chart shows the percentage of S&P 500 stocks above their 200, 150 and 100 day SMAs. Some 79% of stocks are above their 200-day SMAs, 65% are above their 150-day SMAs and less than 50% are above their 100-day SMAs. This is the lowest percentage of stocks above their 100-day SMAs since September-October. Dips into the 40-50 percent range led to bounces in June, September and October (blue shading). However, the current deterioration looks more like the August-September period (red lines). This suggest that we are currently in a late September situation or at the beginning of a corrective period. This means we could see a short-term oversold bounce, but the overall correction could extend for the next 1-2 months.

The next table shows monthly performance for the S&P 500 over the last 25 years and three months stand out for weak performance: February, August and September. These three months show the highest average losses (greater than 4.3%) and the lowest Profit Factors (well below 1). Profit Factor is the total Dollars from gains divided by the total Dollars from losses. Note that April, November and December are by far the best months. You can learn more about seasonal patterns in this report.  

Stocks and junk bonds are underperforming safe-haven Treasuries. The next two charts measure the risk appetite using two ratio charts: the SPY:TLT ratio and the JNK:TLT ratio. The risk appetite is strong when SPY is outperforming TLT and this is bullish for stocks (risk on). The ratio peaked in mid May and broke below its mid June low this week. It also failed to get back above its 50-day SMA in June-July. The middle window shows the 65-day Rate-of-Change for this indicator (three months). It was largely positive from mid June 2020 to June 2021 and is starting to turn negative here in July.

The next chart shows the JNK:TLT ratio (Junk Bond ETF relative to the 20+ Yr Treasury Bond ETF). Junk bonds act more like stocks and they are very sensitive to the economic outlook. Notice how the ratio rose sharply from October to March and this is when the Russell 2000 ETF outperformed. This ratio peaked in March, fell the last few months and broke its 200-day SMA this week. Also notice that the 65-day Rate-of-Change for this ratio has been negative since mid June. Junk bonds are struggling and this also points to risk aversion in the markets right now.

Correction Target for S&P 500

While the major index ETFs are ripe for a mean-reversion bounce that could last a few days, the outlook for the next one to three months is cloudy. The S&P 500 is up over 30% since late October (8+ months) without a decent corrective period (one that lasted more than a month). The last decent correction lasted around 8 weeks in September-October 2020. The red lines show two short pullbacks in March and May. Currently, SPY is up around 8% the last 41 trading days and 9.33% above its rising 200-day SMA. A fairly normal 8% pullback from the current high would extend to the 4037 area and retrace around a 1/3 of the prior advance.

Thanks for tuning in and have a great day!

-Arthur Hill, CMT
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