Waiting for Sector Leadership to Confirm the Rally

We have been tracking some unusual trends in the major indices over the past few weeks. While the S&P 500 has been in a choppy upward trend recently, our analysis is indicating a high level of risk aversion in the market. We have come to this conclusion through the actions of the other indices relative to the S&P 500.

When comparing the S&P 500 to the Nasdaq, the Russell 2000 small cap index and the S&P 500 equal weight index, we are seeing this rally is being pushed by the largest companies in the S&P 500 without participation from those smaller names that make up the entire U.S. market.

Figure 1 shows the relative price performance comparison between the S&P 500 index and the equal weight S&P 500 index. To explain, the price for the S&P 500 index is weighted by market capitalization of the individual components that derive the S&P 500. Thus, larger companies will have a greater impact on the index. When one takes each component and weights them EQUALLY, the gains in the index are much more muted.

In the case of the this comparison, the S&P 500 is up 6.6% over the past thirty days, while the S&P 500 equal weight is up 6.1%. As we mentioned, this divergence typically signifies a built in aversion to risk on the part of investors and means the market is ready to make a move, up or down.

The same holds true for the S&P 500 comparison to that of the Nasdaq. Return comps are hitting extreme divergent readings as seen in figure 3 and tells us to prepare for a move either way. Figure 5 shows the same analysis for the Russell 2000 small caps.

We are getting extreme divergent readings as it relates to cross comparison index price performance. Despite the choppy uptrend we are trading in the S&P 500, there will be a make or break moment soon enough that will propel us into a new trend cycle. Either investors will expand on their aversion towards risk OR risk tolerance will increase and the periphery indices will confirm this current cycle.

Encouraging signs from the last few trading sessions

The trick is to spot the potential for a market trend and prepare accordingly for best case and worst case scenario. Our trend and behavioral models have had a bullish slant to them since June and we have been building our long positions.

We are encouraged about being on the right side of the trade given the market action over the last few trading sessions.

The TQQQ etf is an instrument that we hold in our portfolio and represents that Nasdaq 100. Looking at figure 7, we are pleased with the support the 200 day moving average has provided allowing the etf a pattern of higher lows. Given the lack of performance relative to the S&P 500 as discussed earlier, there was a significant resistance level around $52.00 per share. Given the recent break above $52.00, we are hopeful that this action will (1) translated into a more robust and healthy market rally and (2) provide this etf with a strong support level at $52.00 thus allowing to increase or position in order to enhance returns this year.

We are hoping for a similar breakout in URTY, the Russell 2000 etf that has been in somewhat of a funk over the past few weeks. A sustainable breakout here what also boost our case for a more solid market rally into the close of the year.

UPRO, the S&P 500 etf has been in a pleasing upward channel showing healthy higher highs and higher lows. This instrument has been a stellar performer in our portfolio and further bullish confirmation is likely given the trends over the past several trading sessions.

Transports missed the rally

One potential fly in the ointment is the lack of participation from the Dow Jones Transportation Index. As seen in figure 10, the transports have severely lagged the Dow Jones Industrial Average. According to Dow Theory, this is a big negative and signifies both market and economic weakness ahead. For the most part the rail companies have been doing fine but land logistics and airlines are getting hurt.

Looking at the performance of all the S&P 500 sectors, we have seen an improvement to date but still do not find the strength in cyclical sectors that one would liken to a healthy bull market.

We are at a teetering point in which the market can aggressively move in either direction. Given much of the evidence, it is our opinion that we are heading higher from here and will be watching for supporting evidence of such through our sector and index analysis.

Euro Crisis follow-up

Aside from the better-than-expected but still dismal employment report on Friday, the market got yet another boost from news coming out of Europe. Despite tough talk from Mario Draghi, head of the European Central Bank last week, he seemed to back pedal a bit in his remarks last Thursday. In so many words his proclamation of doing everything in the ECB’s power to preserve the euro and even assuring us not to worry, their action will be enough to curb the bond vigilantes morphed into something like “we’ll help if you ask nicely”. We’re paraphrasing of course but the market DID NOT like these comments as global equity markets sold off aggressively.

On Friday, there was a positive turn of events in which Mariano Rajoy, the Spanish Prime Minister indicated he would request assistance only after he reviewed all terms and conditions attached to the bail-out.

This was a significant statement because it represents the first time since being elected to office some seven month ago that he did not completely reject the notion of a bailout and actually had an epiphany that perhaps one is needed.

Spanish yields have settled below 7% for the past few days. We will be watching for sudden changes in yields for a heads-up on the next round of crisis management from European leaders.

Joseph S. Kalinowski, CFA