The Small-Cap Stock Pattern We're Watching

The SPY 247 strike lived up to its magnetic potential during July options expiration week

Jul 24, 2017 at 8:44 AM
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Nothing good lasts forever. After 10 consecutive positive trading days for the Nasdaq Composite (COMP - 6,387.75), the momentum finally stopped, and stocks took a breather last Friday. This was the index's longest winning streak in more than two years. Don't get me wrong; last week was not a bad one for the stock market or the index, by any means. In fact, the COMP continued its upward trajectory throughout most of the week, in lockstep with the S&P 500 Index (SPX - 2,472.54), to new high after new high.

The old saying that "the trend is your friend" has never been truer than in 2017. Every dip has been a buying opportunity, and momentum has begotten more momentum time and time again. At times, we have seen periods of brief consolidations and sideways price action, but they have been merely breaks in what has been a very strong bull market. In fact, the SPX has not closed below its 80-day moving average since Nov. 8, 2016.

spx daily 0721
Chart courtesy of StockCharts.com


In addition to the strong trend, the options market had something to tell us during standard July options expiration last week. As Todd Salamone mentioned in Monday Morning Outlook a week ago, there was a large amount of July call open interest at the SPDR S&P 500 ETF Trust (SPY - 246.88) 247 strike. Most of these call options were bought to open, which means that market makers who were short the option would have to buy S&P 500 futures to hedge the position if SPY began to approach this strike. This proved to be the case, as the heavy open interest at 247 combined with the existing technical momentum to act as a magnet for SPY.

spy open interest by strike 0721


Second-quarter earnings reports have also begun coming across the news wires and so far, they have been strong. According to FactSet's latest report, expectations for year-over-year earnings per share growth is +6.8%, which is slightly higher than the +6.6% expected on June 30. Some of the companies that had strong reactions to their earnings reports last week included Netflix (NFLX), Johnson & Johnson (JNJ), Morgan Stanley (MS), Visa (V), and Capital One Financial (COF).

On the flip side, a few companies missed the mark, and it had a strong effect on the Dow Jones Industrial Average (DJIA - 21,580.07). During a week where the SPX and COMP both surged higher day after day, the Dow failed to stay afloat, and finished the week in negative territory. Given that it's a price-weighted index consisting of only 30 stocks, a few bad apples can certainly spoil the whole bunch.

So, who were the culprits? It was primarily Goldman Sachs (GS), IBM (IBM), and Travelers Insurance (TRV) that failed to impress market participants with their earnings report. Away from the earnings front, Home Depot (HD) reacted negatively to news that Sears (SHLD) has agreed to sell its Kenmore appliances on Amazon (AMZN). The news led most to believe that Amazon is set to compete more directly with home improvement stores, sending HD shares down 4% on Thursday.

djia daily 0721
Chart courtesy of StockCharts.com


One area of the market we haven't discussed yet is small-cap stocks. You could argue that the Russell 2000 Index (RUT - 1,435.83) has been forming an ascending triangle formation since late April. The resistance area overhead seemed to be the 1,415-1,425 area, which capped rallies in March, April, and June. The index firmly broke above these levels, reaching as high as 1,452, before closing at 1,436. Due to this resistance area, the small-caps are not quite as overbought as indexes like the S&P 500 and Nasdaq Composite. Perhaps the small-cap sector taking a leadership role would not be out of the question going forward.

rut daily 0721
Chart courtesy of StockCharts.com


There were some political and economic developments during the week, although none of them seemed to shake the market in any meaningful way. Senate Majority Leader Mitch McConnell cancelled the vote on the GOP's bill to replace Obamacare after it was determined that they would not have the necessary votes. It appears the Senate's plan now is to simply repeal Obamacare with a two-year delay, which would leave more time to come up with a new plan.

Elsewhere, the Bank of Japan and European Central Bank left rates unchanged, although most came away with the notion that both organizations weren't in a hurry to ease back their accommodative policies any time soon.

Speaking of accommodative, market participants are leaving almost no chance for another rate hike from the Fed at this week's upcoming meeting. The CME Group's Fed Watch Tool indicates a 3.1% chance for a rate hike on Wednesday. The odds don't get much higher for the September or November meetings, either. In fact, more and more participants are starting to think the next rate hike won't even occur until early 2018.

Regardless of short-term rate hikes, long-term rates are dancing to their own music and continue to climb in 2017. As of Friday's close, 30-year interest rates on Treasury bonds are down 8% this year. This dichotomy between short-term rates and long-term rates indicates that the yield curve is starting to flatten, although it is far from flat or inverted at this point. It is something worth monitoring on a continual basis, as inverted yield curves can sometimes precede periods of diminishing economic and/or equity returns.

In the short term, it would not be a surprise if we see some of the major indexes experience a slowing of the momentum generated the past few weeks. Most of their Relative Strength Index (RSI) indicators reflect the fact that they are near, but not yet at, overbought territory. During this uptrend, when the indexes' respective RSIs approach or surpass 70, they tend to undergo a bit of a pause. It is also important to note that becoming overbought has not historically led to any major bearish consequences whatsoever. Strength like this normally means even more strength down the line.

That said, strong markets like these aren't always the most exciting, and the low volatility reflects that. As of right now, there are no flashing signals or warnings that this trend is over or in trouble. Most major trendlines remain below current prices, and are trending strongly upward. Valuations continue to be high, but have been for quite some time. In addition, we are seeing companies beat both earnings and revenue expectations and a growing economy.

This week is one of the busiest of earnings season, featuring companies such as Alphabet (GOOGL), Caterpillar (CAT), General Motors (GM), AT&T (T), Chipotle Mexican Grill (CMG), Boeing (BA), Ford Motor (F), and Facebook (FB). The other big news on tap will be the Fed meeting I mentioned earlier, along with June's existing home sales, durable goods, and GDP data.


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