Breadth Turns Bearish As Small Caps Lead Us Lower

Includes: IJR, SPY
by: Phillip L. Clark

The events over the last week remind us that volatility and opportunity never go out of style. Two weeks ago, stocks were hitting all-time highs and bullishness appeared the notion of choice. Conversely, stocks were under pressure last Friday morning after an unexpected decline in March retail sales. Albeit a small decline, stocks are vulnerable and traders are looking for any reason to hit the sell button. Selling pressure, however, was short-lived as the major indexes regained their footing by mid-morning and edged higher through the close. Despite this intra-day recovery, many key ETFs finished lower on the day.

The ability to recover on another set of disappointing data is impressive, but there are some serious weak spots in the market and all is not well. Looking across the sectors, Basic Materials and Energy were slammed as oil and metals moved lower. Spot Light Crude fell around 5%, Gold was down over 5% and Copper fell 2.64%, in just one day. Weakening economic indicators out of the U.S. sent a harsh reminder that equities could be overpriced at current levels. Increasing our concern for some kind of correction, consumer sentiment, last month, hit a nine-month low and March non-farm payrolls were very weak.

This economic soft-patch would not be so significant if the S&P 500 (NYSEARCA:SPY) and other indices were trading at lower levels. Instead, the S&P 500 and the Dow Industrials are resting near multi-year highs and priced to perfection. This ostensible strength in the S&P 500 and Dow Industrials, however, could be a cloak to some underlying weakness that is revealed by relative weakness in small and mid-cap stocks, which continue to lag the big caps. Furthermore, such strong [unusual] leadership in defensive equity sectors has traditionally been consistent with declining global stock prices. This preference for relative safety is a potential negative for markets. Even though the overall trends remain up, it is hard to be too bullish on stocks right now. Monday's precipitous drop across all sectors accentuates the not so obvious fundamental data that is often ignored during market advances. On the other hand, investors have come to expect a mid-year pause in the economy and the notion of impulse selling can't be ruled out. In fact, the latest broad-based sell-off could be sending a corrective message. It will take a few weeks before a trend can develop.

There are many imbalances around the world: debt deflation pressures remain intense, and the authorities have been forced to counter with unorthodox easing. Small-Cap underperformance is one metric that emphasizes the technical deterioration of late, but choppy economic data and recent political backsliding in Europe have added to the anxiety. The U.S. has struggled with the lack of job generation, and job growth has been concentrated in a few lower-paying segments. Manufacturing has suffered and China's GDP ticked lower than expected. Retail sales have weakened [-0.4% versus flat consensus expectations], which leads us to believe that fiscal drag is taking a toll, especially on discretionary spending. This softening of retail sales calls attention to slower consumer momentum; weak spending in the second quarter can't be ruled out following this data.

Through all of the capricious economic data, some good news can be found. The global economy is strengthening, a soft landing can still happen for China and the U.S. recovery is broadening. The eurozone's contagion should remain limited in spite of the Cyprus catastrophe. Importantly, nearly all central banks are determined to provide reflationary conditions. Such an environment can lead to a progressively encouraging environment for equities and cyclical investments in particular. Nonetheless, no one can guarantee that stocks will finish in the green for 2013 despite the strong start to the year. Therefore, we remain focused on positive signs, which signal sufficient growth that could support a rotation from a defensive style market to risk-on. For that to happen, the economy [global and domestic] will need to be on its best behavior and avoid a repeat of recent unpleasant themes.

Turning to the charts, our technical view has become quite mixed. The S&P 500 is vacillating near all-time highs and the market's next major move should provide a clearer signal of sustainable direction. The index formed a double-top in early March near 1570 and a double bottom near 1535. Unlike the usual wedge formation within a channel, the index has experienced increased volatility, and consequently, risk. In other words, the market reaches selling pressure near 1570 and buying pressure near 1535. To break through the resistance level and find new highs, momentum from earnings or other economic data will be needed. Recalling the aforementioned relative weakness in small-cap stocks, we note that such a move foreshadowed the last two corrections.

Monday's sell-off was led by small-caps; Russell 2000 ETF led the way. Using S&P 500 Equal-Weight index (favors the smaller companies in the S&P 500 because it represents the bottom 450 stocks) and the S&P 500 index (market-cap weighted index that favors large-caps), we create a chart that measures small and mid-cap performance against large-cap performance. Why do small and mid-caps matter? These companies are generally less diversified, more dependent on domestic consumers and more vulnerable to economic changes. Such stocks appeal to appetites for higher risk and tend to underperform when such risk weakens. Our specialized chart measures the performance of small caps relative to large caps. In general, stocks perform well when small caps outperform or perform in line with large caps. Conversely, stocks tend to experience selling pressure as small caps underperform large caps and the price relative breaks down; breakdowns in this ratio gave clear signals ahead of the last two 10% plus corrections. As of Wednesday's close, our price relative ratio chart has dipped below its support line. This signal of weakness in small and mid caps shows risk-aversion and should be considered negative overall. Further deterioration in this metric increases our concern for a near-term correction. Accordingly, we are monitoring events closely and expect the market's next move to begin as several major corporate earnings reports are announced over the next several days.

Last, but certainly not least, our breadth indicator has turned bearish for the S&P 500 following bearish divergence, which began forming in late February. After peaking in late January, a series of lower highs ensued and support was broken this month. In other words, breadth was weakening as the market continued its rally. Looking back to January, 93% of S&P 500 stocks were above their 50-day moving averages, but that number fell to 82% by mid April. That's not to say that 82% isn't respectable and notably strong, but participation continued its decline as the indicator plunged below 60% on Monday. Breadth is trending lower and we consider this bearish. Prior bottoms in the index occurred AFTER the indicator moved below 30%, which means this could be just the beginning of a significant correction. At this stage, protecting profits is a high priority and best obtained by tightening your stops and raising cash if selling pressure increases. You never know, but I suspect there is more selling ahead.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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