From the desk of Steve Strazza @Sstrazza and Louis Sykes @Haumicharts
At the beginning of each week, we publish performance tables for a variety of different asset classes and categories along with commentary on each.
Looking at the past helps put the future into context. In this post, we review the relative strength trends at play and preview some of the things we’re watching in order to profit in the weeks and months ahead.
We discussed markets remaining more or less a mixed bag over recent weeks/months. At the same time, we’ve pointed out how the weight of the evidence continues to tilt gradually in the direction of the bulls, particularly due to the action we’ve observed in key risk assets.
This week, we finally witnessed a meaningful rotation into reflationary assets as yields rallied to their highest levels since June. We also saw a noticeable strengthening from cyclicals.
We think this kind of rotation is a very healthy development for markets.
When investors bid up more economically sensitive assets it speaks to bullish risk-appetite. Let’s go through some of them below.
As usual, we’ll start with our US index table.
Last week was more of the same price action we’ve seen for the previous few weeks. Indexes continue to look choppy in the near term as leaders such as the tech-heavy Nasdaq 100 $QQQ are consolidating.
We continue to get mixed messages like the defensive Dow Utilities Average $DJU performing alongside SMID and Micro-Caps. Although on balance, we remain in an increasingly risk-on environment.
Financials, which we’ll be discussing in-depth throughout this report, alongside other risk assets such as Transports $DJT and SMIDS continue to catch a sustained bid.
The most important story for our US index table is the continued outperformance from the smaller cap indexes over their large and mega-cap peers.
Despite the S&P 500 $SPY and Nasdaq 100 $QQQ still being below their September highs, Mid Caps $MDY, Small Caps $IWM, and Micro Caps $IWC are all above their August/September highs.
Rotation down the market-cap scale is indicative of positive risk appetite for US equities, and just one of many data points that support our bullish thesis moving into the fourth quarter.
Considering SMIDs have been the secular laggards for some time now, leadership from this group speaks to the growing participation and broadening leadership in the market.
While the Nasdaq and S&P are consolidating within the context of structural uptrends, SMIDS are finding their footing and showing near-term leadership while the large-cap leaders cool off. We’ve been waiting for years to see this rotation as the smaller averages have remained trapped below overhead resistance at their 2018 and Q1 highs. This expanding participation is a cornerstone characteristic of bull markets.
One aspect of these smaller-market cap indexes is that they have larger weightings in more cyclical sectors, such as Industrials, Materials, and maybe most importantly, Financials. If SMIDs are leading Large Caps, that is likely occurring in an environment where Financials and other risk-on, cyclical sectors are performing or even leading the market higher.
If we zoom in on Small Caps $IWM relative to their Large Cap counterpart $SPY, we can see they’re attempting to carve out a bottom and potential bearish-bullish trend reversal.
Seeing this small-cap outperformance is consistent with this week’s action of Financials showing relative strength and rates moving higher.
If this ratio is above the June highs, we think it’s prudent to expect Small Caps to begin outperforming Large Caps over the intermediate-term.
The impact of Financials and Small Cap rotation is likely to be at the cost of the relative strength in Technology and the Nasdaq.
The Nasdaq 100 $QQQ relative to the Nasdaq Composite $COMPX has been breaking down since the September highs in equities. Why are we looking at this and what does it mean?
The Nasdaq 100 has less than a 2% weighting in cyclical sectors (all industrials). Meanwhile, the Composite has about a 12% weighting in cyclicals, with almost half of that coming from Financials which have no presence at all in QQQ.
If this rotation becomes sustained, we think Technology is going to come under increased pressure on a relative basis as leadership shifts to other areas of the market.
This is simply more evidence of broadening participation.
This same thesis is being supported by our breadth metrics as well as other price-based indicators such as the Equal-Weight S&P $RSP making higher highs and diverging from the Cap-Weighted S&P.
Now, moving onto our Sector ETF table.
This week, our sector table remained fairly mixed. Technology $XLK was the biggest loser of the week, down over 2%, with Communications $XLC booking the largest gains.
Financials $XLF also booked a solid 1% gain and are actually the 2nd best performing sector over the trailing month. It’s been a long time since we’ve been able to say that.
In last week’s report, here’s what we said about Financials:
Bonds, rates & yield spreads, financials & banks – they’re all very correlated. It’s all a part of the reflation trade we’ve talked about so much in recent months.
So, if we finally get some rotation into the sector it’s very likely to occur in an environment where yields and yield spreads are rising. That will be a major positive for stock bulls and bond bears.
Financials and rates continued to affirm our outlook this week, with Banks $KBE closing higher by over 6%. Let’s dive deeper into this area.
Because of Financials’ correlation with interest rates, bonds, and risk assets alike, it can be deduced that any movement in this ratio is evidence of risk-appetite for the broader market.
We’ve covered this sector many times and we ultimately come to the same conclusion. Various areas of the market such as risk-on currencies, commodities, factor ratios, SMIDS, and the fixed income market all remain supportive of higher prices for Financials… yet, we still haven’t seen it.
While the evidence continues to suggest that Financials will eventually assume leadership, we still need to be patient and wait for this relative trend to develop. There’s more on this below.
To continue the theme of cyclical areas, one sector we’ve mentioned a lot in previous RPP Reports is Industrials.
Like SMIDS, Industrials $XLI have managed to break above their September highs, while other secular leaders, such as Technology $XLK have yet to do so.
In our eyes, this all fits into the same theme – the balancing of sector leadership.
It’s not just Technology, Consumer Discretionary, and Communications doing all the heavy lifting anymore. Major cyclical sectors, particularly Industrials and Materials are now trying to pick up the slack and lead.
We witnessed a similar reflationary environment when equities bottomed in 2009, 2012, and 2016, where yields moved higher acting as a tailwind for risk assets and cyclical areas of the market.
The recent price action is telling us that our current environment is becoming increasingly similar to those periods.
Let’s move on to our Industry ETF table.
Can you guess who’s the big winner this week and over the trailing month? Banks… by a mile. They are up more than 20%, more than double any other industry on our list on a monthly basis.
Like Financials, when was the last time we could say such a thing?
While it is important to recognize that Software $IGV, Medical Devices $IHI, and Semiconductors $SOXX continue to lead over the last 3 months and trailing year, a sustained bid from such an important laggard as the Banks $KBE is a major development we ought to pay attention to.
For this chart, we’re looking at Banks and Financials relative to the S&P 500.
While Banks are now decisively above their May lows after jumping higher following a failed move, the wider Financials sector is still squandering below that same level.
Will XLF soon follow KBE? Based on what we’re seeing, we think that answer is yes.
If that is the case, these two charts would represent major failed breakdowns, and what do we know about failed breakouts/breakdowns?
From failed moves come fast moves in the opposite direction.
If these two ratios remain above the May lows, the risk is to the upside.