S&P 500 RETESTS 200-DAY MOVING AVERAGE AND TWO-YEAR SUPPORT LINE -- VOLUME PATTERN HASN'T BEEN ENCOURAGING -- SMALL CAPS CONTINUE TO DROP FASTER THAN LARGE CAPS -- A RATIO OF SMALL CAPS VERSUS LARGE CAPS IS NOW TESTING MAJOR SUPPORT
S&P 500 CONTINUES TO TEST MAJOR SUPPORT LINES... After a rebound attempt on Tuesday, stocks ended the week pretty much where they started, but on the defensive. The daily bars in Chart 1 show the S&P 500 Large Cap Index closing Friday right on its 200-day average (red line). The green trendline is drawn under previous lows starting in February 2016. Needless to say, that's also an important test of a major support line. Volume patterns haven't been encouraging. Volume has tended to lighten on price bounces and increase when prices drop. That was especially true when Tuesday's impressive price rebound took place on notably lighter volume. Volume picked up again on Thursday and Friday as prices retreated. That should make next week an especially important one. I wouldn't be surprised to see stocks weaken at the start of the week. How they end the week is more important. Seasonally, stocks usually get a bounce later in the fourth quarter, especially in midterm elections years like this one. Hopefully, that will be the case once the current downleg runs its course. My longer range work continues to suggest that stocks are going through a topping process. But that doesn't rule out a rally as we move closer to November, especially with stocks approaching a more oversold condition. Any fourth quarter bounce, however, should probably be viewed as a selling opportunity. Sector rotation into defensive sectors and out of economically-sensitive stocks appears be sending an SOS market signal. That translates into "Sell On Strength".
Chart 1
SMALL CAP WEAKNESS IS A BAD SIGN ... It's usually not a good sign for the stock market when small cap stocks are leading it lower. But that's just what they've been doing since the start of the fourth quarter. The daily bars in Chart 2 shows the Russell 2000 Small Cap Index falling below its 50-day average (blue line) at the start of the month which turned its short-term trend lower. It was the first of the major stock indexes to do that. Two weeks ago the RUT fell below its 200-day average by the widest margin of the year. That's not a good sign for them or larger stocks. That's because small cap stocks have a history of leading large caps higher at market bottoms, and leading them lower at market tops. Right now they're leading them lower. Various measures of market breadth have also been weakening. A lot of that weakness is coming from small and midcap stocks. That's partially because there are a lot more smaller stocks than larger ones. Plus the fact that major stock indexes like the S&P 500 are capitalization weighted, which means that they give more weight to larger stocks. And less weight to smaller ones. That's why large cap stock indexes usually peak after smaller ones. And why small cap stocks are usually a leading indicator for bigger stocks. We saw a small example of that on Friday. While the large cap indexes were trying to hold onto modest gains in the afternoon, small stocks were down more than 1% on the day. So it wasn't much of a surprise to see the S&P 500 end the day in the red. It's hard for larger stocks to rally when small caps are falling.
(click to view a live version of this chart)
Chart 2
SMALL CAP/ LARGE CAP RATIO IS TESTING IMPORTANT CHART SUPPORT... The blue line in Chart 3 is a relative strength ratio of the Russell 2000 Small Cap Index divided by the S&P 500 Large Cap Index. First of all, notice the strong upturn in the ratio at the start of 2016 which helped launch the last upleg in stocks that started that year. That's normal behavior since small caps usually do better at market bottoms. The opposite is true, however, at market tops. Chart 3 shows the ratio peaking this summer at the same level formed at the end of 2016. It has since fallen to the lowest level in nearly two years. That's a very important test. A decisive break of those lows would, in my opinion, be an even more negative message for small caps and the rest of the market.
