A closer look at the small-cap chart pattern that "screams indecision"
"Do not be surprised if round numbers like SPX 3,000 and Dow Jones 27,000 act as barriers in the short term. For what it's worth, SPX 3,008 is around 20% above the 2018 close, and could act in concert with SPX 3,000 as resistance. There was evidence of this resistance on Wednesday and Thursday, as the SPX effectively went sideways after a quick push up to 3,000, when Jerome Powell's prepared remarks to Congress were released before his actual appearance."
-- Monday Morning Outlook, July 15, 2019
The S&P 500 Index (SPX - 2,976.61) started the week by trading right up to the +20% year-to-date level, only to immediately pull back below the round 3,000 level by the end of the week. Regular readers know that we think the broader equity indexes could be setting up for an explosive move, but also that it will take a little time to set up.
Last week, we struggled with the round SPX 3,000 millennium level in the second week of earnings season, as we largely expected. We also have a potential gap to fill down at the 2,940 level, and I expect this indecisive market behavior has a high probability of continuing for the next week, while we await the outcome of the highly anticipated July 30-31 Federal Open Market Committee (FOMC) meeting.
Market participants have fully priced in that the Fed will cut rates by 25 basis points, and it can be argued that they want 50 basis points -- but I don't think they'll get what they want. The Fed has said before they are data dependent, and while we've continued to see softening in some indicators -- like a slowdown in the ISM index and a negative Leading Economic Index (LEI) -- I don't expect for the Fed to act aggressively until it needs to.
For instance, the LEI has acted similarly in multiple contractionary periods, but not all of those led to significant market declines. What is different about the negative contraction in the LEI is the fact it has been happening while some of the 10-year yield curves were negative, and this has typically led to a better signal of a recession -- but it's still not a guarantee. We'll want to watch Friday's gross domestic product (GDP) numbers to see if the sharp reversal in the LEI was a precursor for a drop in nominal GDP.
"We can guarantee investors' behavior will change once the curve inverts, which makes this indicator something of a self-fulfilling prophecy. But we'll see other signals in the market, like the Leading Economic Index (LEI) turning negative and relative strength sustaining a rotation toward defensive late-cycle sectors, before we should be concerned."
-- Monday Morning Outlook, July 23, 2018
Additionally, the 3-month/10-year yield curve un-inverted this past week -- but this doesn't necessarily mean it's time to get bullish, either, as these signals have often led to mixed results (similar to our study last week on how the market behaves after the 3-month/10 year curve has been inverted for six straight weeks). The most interesting factor is that the 2-year/10-year yield curve never inverted, which I've noted more than once is the real yield curve to watch. It's significant because that signal has identified nearly every recent recessionary market pullback.
So, while there are plenty of economic concerns -- like the weakening ISM index, durable goods, and personal consumption expenditures (PCE) price index being back below the 2% inflation target -- it still doesn't mean we're heading into a recession. However, we are more vulnerable, as investors' behavior has changed, and now we are seeing more cautionary signs like I stated to look out for a year ago.
Chart courtesy of StockCharts.com
In addition to a negative LEI, another cautionary sign was seeing prolonged relative strength in defensive sectors, which continues to be a theme in the markets. So, while we've experienced explosive spurts of strength back into sectors like technology and consumer discretionary, we've seen that get extended rather quickly -- whereas defensive sectors have had constructive pullbacks to digest gains. Will this continue going forward? Possibly, as long as there appears to be economic and geopolitical risks, we could see these sectors to continue to perform well, with cyclicals being more volatile.
We also continue to see the Russell 2000 Index (RUT - 1,547.89) struggling to break out of a downtrend it's been in since the fourth-quarter sell-off. RUT is consistently being rejected at the upper trendline with lower highs, and unable to break above its May highs, whereas the other broad-market indexes surpassed their prior highs to break out. This was similarly a concern before the May correction, and as soon as the small-cap index failed to break out, the rest of the broad indexes broke down, seeing a 7.5%-10% correction amongst them.
While this downtrend could simply be a giant triangle pattern that we are working through, it is a concern from a technical basis, as asymmetrical triangles are patterns that scream indecision. On a positive note, it does seem to be bull flagging near current levels, which could be a sign it wants to break out to the upside -- but market participants must be careful, as these patterns have a higher probability of failed breakouts. The iShares Russell 2000 Index (IWM - 153.82) might very well be the signal we need to give us a hint to which direction the broader market move will be; we just need to be careful not to get caught flat-footed in case the first direction is not the right direction.
Sentiment data only adds to my point that we'll likely remain in consolidation mode while we await the Fed decision. Sentiment data from the weekly American Association of Individual Investors (AAII) survey remains mixed, as illustrated below. This past week there was little change in the mood among this group of investors, with sentiment likely subdued by everyone waiting on the Fed. So, we're likely to remain in the wait-and-see approach for the week until we get clarification on interest rates from the FOMC.
Matthew Timpane is Schaeffer's Senior Market Strategist.
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