Will Small Cap Weakness Drag Down The Market?

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PPLC, PPSC, PSQ, QID-OLD, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USSD, USWD, UWM, VFINX, VOO, VTWO, VV
by: Clif Droke

Summary

Averages stall out as Wall Street waits for tax bill to be passed.

There are some internal divergences which could make for choppy trading, near-term.

Path of least resistance, however, remains up for NYSE broad market.

After a sharp run-up in late November, many stocks have spent the last two weeks consolidating their gains. While the large cap averages remain strong there has been a measure of weakness recently in small cap and mid cap stocks. The progression of the Dow Jones Industrial Average (DJIA) and S&P 500 (SPX) has masked this internal weakness, which is most evident in the chart of the S&P 400 Mid Cap Index (MID) and the Russell 200 Small Cap Index (RUT), shown below. In this commentary we'll examine the market's current internal condition as we try to determine whether the large cap indices like the Dow and SPX have enough "juice" to continue rallying in the face of small cap and mid cap stock weakness.

Russell 2000 Small Cap Index

Source: www.BigCharts.com

Much of the internal divergence in the small caps in particular can be traced to the "window dressing" which is typical of December before the final quarter ends. Money managers are trying to spruce up their portfolios as the year ends and it's not uncommon for laggards to be dumped en masse. This can create concentrated weakness in a handful of industry groups. This fate has recently befallen the semiconductor stocks as the PHLX Semiconductor Index (SOX) chart shows.

PHLX Semiconductor Index

Source: www.BigCharts.com

One source of internal weakness in just the last couple of days has been the financial sector. The flattening of the yield curve was felt by the financial sector this week after the FOMC raised the fed funds target range by 25 basis points to 1.25%-1.50% on Wednesday, marking the third rate hike of 2017. Only two FOMC members dissented. The Fed's so-called "dot plot" revealed that most FOMC members anticipate three rate increases in 2018 and two in 2019. Both figures were unchanged from the projections released in September, even though the Fed acknowledged that overall inflation and core inflation have declined this year and are running below 2%.

Consequently, the financial space dropped over 2% in the last two sessions. Although the sensitive NYSE Securities Broker/Dealer Index (XBD) remained above its 15-day moving average as of Dec. 14, it's on the verge of breaking under this useful delineation of the immediate-term (1-4 week) trend. The XBD is also an important leading and confirming indicator for the broad market. A weekly close under the 15-day MA would send a "heads up" signal that would likely be followed by an increase in choppiness for the stock market, near term.

NYSE Securities Broker/Dealer Index Source: www.BigCharts.com

Another indication which suggests some market turbulence might be imminent is the following graph. This shows the cumulative progression of the S&P 500 Index's closing hour of trading on a daily basis. The closing hour is important since many fund managers and hedge fund traders close are known to close and initiate trading positions in the final hour of the trading day. It's not surprising then that this indicator has been useful at times in predicting market volatility, especially when there is a conspicuous divergence between the daily price line of the S&P and the closing hour indicator. As can be seen here, the closing hour indicator has begun showing some rather pronounced downside in recent days. While this indicator doesn't have intermediate-term significance, it can provide leading clues as to short-term strength or weakness in the stock market.

Chart created by Clif Droke

Yet another potential source for some near-term choppiness is found in the political front. I'm referring of course to the widely anticipated -- and highly debated -- U.S. tax reform bill. According to news reports, the GOP aims to release the full details of the bill on Friday, and Congress is expected to vote on the measure sometime next week. However, equity prices saw some selling pressure on Thursday following news that Republican Senator Marco Rubio will vote "No" on tax reform unless the final bill further expands the child tax credit for lower-income households. This was a cause for consternation since Senate Republicans can only afford to lose two votes, and it's believed that Republican Sen. Bob Corker may vote against the legislation.

The stock market has built up some very high expectations for corporate tax breaks, so a final tax bill which in any way disappoints Wall Street could result in some immediate-term profit-taking which in turn would add to market choppiness. I'll have more to say about the tax bill and its anticipated impact on the financial market and economy once the bill is finalized.

While the potential for heightened choppiness and volatility have increased lately, I would emphasize that the market's dominant intermediate-term upward trend should not be compromised. Indeed, any immediate-term pullbacks would be buying opportunities based on the strength of the NYSE internal indicators we're about to discuss.

To begin with, market internals remain firm despite the recent financial sector and small cap weakness. The daily high-low ratio of recent days has to averaged around 4-to-1, which is a fairly healthy reading. To date there is no sign of internal selling pressure in the overall scheme of the broad market since most of the last several days have seen below 40 stocks making new 52-week lows on the NYSE (a sign of internal health).

Along those lines, one of our most important indicators for confirming the near-term path of least resistance for equities is the 4-week rate of change of the 52-week new highs-new lows. The indicator is shown below as of Thursday, Dec. 14. As long as the directional indicator continues along the rising path it has established in recent weeks, the bulls are assumed to have control over the dominant short-term market trend.

Chart created by Clif Droke

With four of the six major indices (Dow, SPX, NDX, NYA, MID, RUT) showing enough strength to warrant a continued short-term positive bias, there is no reason for action yet in reversing bullish positions in the stock market. The next few days may well be bumpy, but until the internal indicators mentioned above start breaking down I will continue to lean bullish.

Disclosure: I/we 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.