Bearish RUT Chart Pattern Signals Small-Cap Vulnerability

Investors should watch VIX around 14 and 15 for signs of a possible stock market correction

Senior Vice President of Research
Apr 10, 2017 at 8:33 AM
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"... the S&P 500 Index (SPX - 2,343.98) declined back below its pre-Federal Open Market Committee (FOMC) March 14 close of 2,365 to the vicinity of the half-century 2,350 area...This price action mirrored that of mid-to-late December, when the SPX was roughly 20 points above the 2,250 level pre-FOMC and checked back to 2,250 by late December. I have discussed on multiple occasions how SPX half-century marks have tended to act as key pivot points or 'magnetic' levels historically, with the 2,350 half-century mark being no different... it is likely that sideways movement grips the market over the next few weeks -- even as we get set to enter the historically strong month of April."
    -- Monday Morning Outlook, April 3, 2017

"U.S. Stocks Reverse Gains After Fed, Ryan Comments as Bonds Gain"
"Treasuries Yield Curve Steepens on Fed Balance Sheet Plan"

    -- Bloomberg, April 5, 2017

 "U.S.-China Trade Tensions Loom Over Trump-Xi Summit"

    -- The Wall Street Journal, April 5, 2017

"Russia Warns of Serious Consequences from U.S. Strike in Syria"
    -- Reuters, April 7, 2017

Once again, it was a week filled with market-moving headlines that, at a minimum, could send volatility expectations higher and prompt a big directional move for stocks.

For example, the Fed was in the spotlight with the release of its March meeting minutes and hints that it could move to reduce the size of its balance sheet nearer the end of the year. The legislative agenda also came back into play, coincident with Speaker of the House Paul Ryan cautioning that tax reform could take longer than changes in healthcare reform.

Additionally, President Trump met with Chinese President Xi Jinping, therefore bringing trade policy and North Korea back into the headlines.

And of course, on Thursday evening, the U.S. launched missiles into a Syrian airfield, in what is being characterized as a warning to Syria and other countries that the use of chemical and biological weapons will not be tolerated. This action, of course, complicates an already-complicated situation between the U.S. and Russia, as Russia supports the Syrian government.

In the immediate hours after the missile launches, S&P futures traded lower in overseas action -- but barely took out the previous day's lows in the 2,340 area -- before opening just moderately lower at the New York open on Friday.

And at the end of the day, the S&P 500 Index (SPX - 2,355.54) remains range-bound, with numerous tests of the 2,350 half-century mark since the mid-March Federal Open Market Committee (FOMC) meeting, in which the Fed raised rates and reiterated its projected three rate hikes in 2017. As I have been discussing since late March, the 2,350 level has acted as a magnet in recent weeks, very similar to the way the 2,250 half-century mark acted as a magnet following the mid-December rate hike.

Furthermore, just as the mid-December pre-FOMC SPX close around 2,270 acted as short-term resistance in the days and weeks following the mid-December rate hike, I find it interesting (per my Friday tweet) that the 2,364 area has served as resistance, only weeks removed from the March 15 rate hike.

spx daily with half-century marks 0407

Note that it took more than one month after the December rate hike for the SPX to break out of its December-January "holding pattern." For those of you who may not remember, the breakout occurred around the time of President Donald Trump's inauguration, followed by the early March peak that occurred just days before the FOMC meeting. This might suggest that investors are fretting over rate hikes, and the threat of more rate hikes, as uncertainty continues to linger with respect to policy changes that might support economic growth.

In light of this, a Trump administration "win," perceived progress toward a win -- or economic data that suggests the economy is moving along just fine without major policy changes -- could be what investors are seeking to pop benchmarks such as the SPX,  Russell 2000 Index (RUT - 1,364.56) and Dow Jones Industrial Average (DJIA - 20,656.10) above their early March highs.

Keep in mind that those March highs on all three benchmarks occurred around major round levels -- specifically, 21,000 on the Dow, SPX 2,400, and RUT 1,400.  Meanwhile, the tech-heavy Nasdaq-100 Index (NDX - 5,418.37) has been outperforming since early March. NDX hit a new high early last week, but has essentially moved sideways between 5,400 and 5,450, and has been unable to venture far above its close at 5,416 on March 15, the day the Fed raised rates.

The RUT remains the most vulnerable of the benchmarks discussed, as it has been trading sideways since the mid-December rate hike and could be forming a bearish "head and shoulders" pattern.

The neckline of this pattern is at the 1,345-1,350 mark. Just above this area is the 1,357 level -- the 2017 year-to-date breakeven point for RUT -- which is likely lending a hand in support. A close below 1,345 would leave the RUT vulnerable to a decline to 1,280, which is 65 points below the neckline, or the distance between the neckline and the "head" (or March peak).

As such, small caps remain an area to avoid, given the shakier technical backdrop relative to larger-cap names, and specifically larger-cap technology stocks.

rut daily bearish head and shoulders 0407

In the context of the headlines that emerged last week, the CBOE Volatility Index (VIX - 12.87) was relatively muted, making its high last Monday at 13.59, and never coming close to the 14 area that has defined all closing peaks since the election. With the recent intraday peak at 15.11, a potential signpost that equities could be in for a corrective-type move would be a daily VIX close above 15, or multiple closes above the post-election closing high of 14.04.  

"...since December, it has not been a good time to be long stocks in the immediate days after a VIX touch of 11.25..."
    -- Monday Morning Outlook, March 27, 2017

Meanwhile, the VIX has room to decline back to half the pre-election closing high (22.50) at 11.25. As I said two weeks ago, 11.25 has served as a floor since December, and equities have performed poorly in the short term after VIX touches of 11.25 in this time period. The last signal was on March 29, assuming at least five days between signals. Our quantitative analysis team updated the table below with the most recent signal.

spx after vix 11.25

"I remain bullish on gold, and I also think bonds, via the iShares 20+ Year Treasury Bond ETF (TLT), offer decent reward vs. risk over the next month. TLT rallied in the month after the Fed last raised rates in December, and with CoT large speculators showing signs of unwinding a multi-year record short position on the 10-year Treasury note, this could be an attractive asset in the weeks ahead."
    -- Monday Morning Outlook, March 20, 2017

With the equity market grinding sideways amid a litany of headline risks, the risk of a volatility pop lingers. Commitments of Traders (CoT) data shows large speculators, who have been historically wrong at key turning points in volatility, have a huge short position on VIX futures (although there was a little bit of covering the past two weeks). Additionally, shorts have been building positions on individual equities after a period of short-covering that pushed short interest to relatively low levels, and this has become a headwind for stocks over the past few weeks.

As such, you can reduce your exposure to equities by avoiding small-cap stocks. With earnings season getting ready to heat up at the end of the month, it will cost you more to implement the stock-replacement strategy, in which you sell stock and purchase a call option on that stock to reduce your dollar exposure to the market.

I still like bonds, as short-covering continues on the 10-year Treasury note. However, the iShares 20+ Year Treasury Bond ETF (TLT - 120.71) is at the top of its recent range, so do not initiate new long positions until you see a close above $122.25. Keep your TLT stop-loss around $118.80, near the site of its year-end 2016 close.

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