Small Caps Getting Ready to Lead While Worries about Trump Persist

Yesterday, I wrote about the major stock market indices and how the Russell 2000 was finally waking up. Below is an old chart which I first offered in early January. You can see that the small caps have been in a tight trading range all year and are now trying to break out to the upside. With so many studies pointing lower, this is one index which could counter some of the negativity and give the market a little push higher if it can close at all-time highs. That’s another 2% higher from here.

During the snow day, I spoke with several clients who were concerned about President Trump’s behavior. Between the tweeting and executive orders, people were worried about the markets. This is one area I have absolutely no worries at all. Talk is cheap. Actions speak louder than words and we do have checks and balances with the courts and Congress.

Trump is doing a masterful job of keeping Paul Ryan and the GOP-led Congress off the front pages and really out of the media spotlight as they craft very pro-growth legislation while removing unnecessary regulatory hurdles. Ryan and his team are flying under the radar unlike how President Obama’s Congress during his first 100 days.

The markets don’t really care what Trump has to say so far because the comments are not perceived as to adversely impact the economy or markets. Beyond the immigration executive order which has garnered all of the attention, the markets are very focused on lower corporate and individual taxes by Q3 of this year. Companies could potentially have trillions more to work with at home which translates into more jobs, higher earnings and a better landscape if it all can be pulled off.

“IF” is the operative word. As I keep saying, markets are somewhat priced for perfection and if Congress gets bogged down on Ryan’s agenda, that could make the markets frustrated and correct more significantly than the 2-5% pullback we should see sooner than later.

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Buy Small Caps for the Next Three Weeks

In my previous post, Underwhelming Rally but Don’t Count Out the Bulls, I was concerned about another “few percent” pullback given last Friday’s weak beneath the surface rally. So far, this week has been all red and it looks like stocks are getting closer to the low where the Santa Claus rally will begin. While the odds favor one more decline below Wednesday’s low over the coming few days, it’s anything but a slam dunk. I have been pounding the table to buy on weakness, not necessarily trying to pick the bottom. It’s not the time to get cute.

This time of year has a very strong seasonal bias for the Russell 2000 (small caps) to do well both in absolute and relative terms. On a relative basis, small caps tend to outperform the other major indices from early December through mid January. On an absolute basis, they are also strong over the final few weeks of the year and early in the new year.

Through the first 49 weeks of 2015, the Russell 2000 is down by 4.64%. That sparked my curiosity if that portends any trend over the final three weeks. I asked my friend and uber data miner Jason Goepfert from Sentimentrader.com to  help me with the research.

The first result shows all instances of the Russell 2000 being down for 49 weeks and the resulting 3 weeks in chronological order. I also added if stocks were in a bear market or corrective one, which was most of the time including currently.

The second table was sorted by the poorest 49 week returns to best. Finally, the last table shows the best final 3 week returns from weakest to strongest. The bottom line is that the trend says it’s a good time to own small caps although the best final 3 weeks in the Russell 2000 usually occur during bear markets.

Study

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Don’t Count the Bulls Out to Begin 2015

Welcome to 2015! Wishing you and your family a very Happy, Healthy, Safe and Peaceful New Year!

Stocks finished 2014 with a whimper rather than a bang as the lack of liquidity allowed sellers to move prices sharply lower on Wednesday. The last two days of December have become somewhat of a headwind lately, but that weakness is supposed to be reversed next week. As bullish as I was over the past few weeks on the small cap Russell 2000, the trend is now to own the S&P 500 and Nasdaq 100 to begin the year. It’s also the time when the cheap, beaten down stocks from 2014 are supposed to get a bid and see higher prices over the coming 1-2 weeks.

I am sure the bears will come in to 2015 all fired up having won the battle on Wednesday, but I suggest caution in getting too negative too quickly. The time for that should come multiple times this year and possibly as soon as the next  few weeks, just not right now. The first week of so of the New Year usually sees some crosscurrents not limited to the previous year’s leaders being laggards and vice versa. I am focused squarely on the energy sector for signs that trend is taking shape. Crude oil looks like it can bounce to begin 2015, but it doesn’t yet exhibit signs of THE bottom just yet.

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Homestretch

This is it. Three more trading days and 2014 will be in the books as they say. Just 8 trading days ago, the bears were beating their chests yet again about how the bull market ended or the stock market was in 10%+ correction or a whole host of other nonsense. I wrote it right at the October bottom and I did the same thing 8 days ago; the bull market is old yet alive and weakness should be bought right away. Don’t count out Ole Saint Nick! If you followed that advice you were instantly gratified.

Dow Industrials – All time highs

S&P 500 – All time highs

S&P 400 – All time highs

Russell 2000 – All time highs

Reread that last one. Russell 2000 all time highs. The index that was left for dead by all the bears. Where are all those naysayers now? Awfully silent!

The only major index still waiting to celebrate the New Year at a fresh high is the Nasdaq 100. The odds do favor this laggard stepping up over the coming weeks to join its cousins.

Year after year, I have written about the many crosscurrents this time of year to go along with some very powerful trends. Are they perfect? Not even close. Do they win 9 out of 10 years? Nope. But they do provide a much better than average result when followed properly.

Interestingly and uncharacteristically, we don’t really have a standout leader index since the December bottom. All of the major indices have basically seen returns in the same range, something I do not expect to continue. I am sure you are now wondering if I think everything is hunky dory and we should just mortgage the house and go all in to stocks. Absolutely not. The time to do that was in October or last January or many other short-term bouts of weakness since 2012.

As I wrote about over and over and over during the fourth quarter, it is beyond unusual to see a major peak late in the year, especially during an uptrend. There is little impetus to sell. And let’s not forget about the pension and mutual fund managers trailing their benchmark and in dire need to pay performance catch up.

But the calendar is turning this week and I do see some minor market cracks that need to be fixed. I don’t like that over the past three days stocks lost momentum during the afternoon and closed in the lower end of the daily range. I also want to see the high yield bond market regain its footing in the face of volatile energy prices.

This won’t be the last time I write this next comment. 2014 was hard to lose a lot of money and it was a tough year to make a lot of money. I don’t think we have the same landscape in 2015. Things are about to get really interesting…

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Santa Claus Rally Just Around Corner

Big picture. Late October through mid January is the strongest seasonal period to invest in stocks. That’s fact.

Over a similar but slightly different period, the semiconductors are the strongest group to invest in. Just since the October bottom, they are up 27% and I am very glad we own them in our sector program. They made up for some crummy positions we have held during the same time.

Early December shows some slightly negative seasonal headwinds, like we are seeing now. In bull markets, these headwinds usually turn to tailwinds over the coming week.

The much maligned and beaten down Russell 2000 index of small cap stocks has its most favorable period right now through early January, one of the “January Effects”. Tuesday’s wide daily range in the Russell turned the index from breakdown mode to possible breakout mode next week or the week after.

The traditional year-end or Santa Claus rally often seen in bull markets is set up to begin shortly and take the Dow above my longstanding target of 18,000 with the likelihood that small and micro cap stocks finally show some outperformance in an otherwise crummy year for them. I would be concerned and question that scenario if the Russell 2000 closed below Tuesday’s low, roughly 2.5% lower from here.

There are always many crosscurrents in December and this year is no different with most of the market doing well, while the energy sector is under severe pressure. Tax loss selling in energy stocks is supposed to wrap shortly and that group should see at least a reflex rally, regardless of where it is going next year. At the same time, with so many portfolio managers trailing their benchmarks, it’s very difficult for the bears to make any headway until next year. Any 1-3% decline should be quickly gobbled up, especially in the sectors and stocks that have performed the best in 2014.

Like I said, lots of crosscurrents through year-end…

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Dow 18,000 Next as Twitter, Investors, Advisors and Media Root for Bears

Small Caps Play Catch Up in BIG Way

When we last left off, the major stock market indices were all playing nicely together except for the small cap Russell 2000 which had seen a full fledged 10% correction, but was beginning to bounce. The performance of that one index was a key ingredient to the bears’ negative stance on the market. At that time, here and on the blog, I dismissed the Russell’s warning and went so far as to call for all time highs before long.

On the first day of the new month and quarter, the Russell 2000 joined the S&P 500, S&P 400, Nasdaq 100 and Dow to score fresh all time highs. At the same time, the New York Stock Exchange Advance/Decline Line, which is a barometer of health on the NYSE also saw a new all time high along with many other sectors and indicators. This continues to be intermediate and long-term positive for the bull market.

More shorter-term, the market can best be described as grinding or creeping higher day after day. When you are on the correct side, there is nothing better. This kind of market has been seen many times since 2009 but rarely before that. The most common ending is a sharp and fast decline that wipes out a lot of gains in short order but does not end the bull market. At some point that scenario will become more likely.

The Market People Love to Hate

Remember, as I have now said for two years, this bull market may be old and wrinkly, but certainly not unhealthy or about to die. It continues to be the most unloved and disavowed bull market of my lifetime. Instead of friends asking me for the latest or greatest “hot” tip which I would expect at Dow 17,000, I am frequently pushed to opine as to when this all ends or when the big correction is coming.

And it’s not just individual investors. On a daily basis I speak with other advisors as well as the media. It really surprises me how many peers have been negative, are negative and will be negative. This is a market where people in my industry should be raising lots of money. Markets have been “easy”, meaning there has not been any significant downside since June 2012.

I think it’s very hard to run an investment management business being a perma-bear or holding on to the belief that although stocks have rallied, they remain in a secular (long-term) bear market that began in 2000 with the Dow at 11,750. That’s crazy in my humble opinion.

On the media side, they may have finally realized that I have a better face for radio than TV, but it certainly feels like they are not as interested in my bullish stance anymore now that the market has rallied. I have lost several opportunities lately because my opinion wasn’t bearish or I wouldn’t forecast some kind of doom (my word) on the horizon.

You can accuse the Fed of manipulation or supporting the market or anything you want. But the reality is that this has been one of the most powerful bull markets of all time. From my seat, as long as investors ask questions about the downside, advisors are bearish, the media only wants to sell negativity and my Twitter feed is full of bears, the bull market will live on.

How It Usually Ends

Yes, the market is 33 months from its last 10% correction and some surveys show complacency, but bull markets do not usually end with a whimper. There are typically many warning signs long before the bear comes out of its cave. Today, we have almost none. Additionally, the market historically sees a 10% correction where the end of the bull market is claimed by the masses, only to see yet another rally to new highs take shape. We haven’t even seen the correction yet. And before the 10% correction, there should be a modest 2-4% pullback.

Don’t get me wrong. Investors need to remain vigilant and active and on top of their holdings. Or hire someone like me to do it! (Shameless plug) Throwing caution to the wind and taking a “get me in at any price” mentality will likely end in ruin. Eventually, stocks will pullback, probably sooner than later, and finally correct 10% or more. But as I have been saying for years, any and all weakness remains a buying opportunity until proven otherwise. These kinds of markets are rare and should be fun. It’s too bad that so many can only see negativity.

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Russell Trying to Join Party

Over the past few months I have often warned about the caution signs being given by the major stock market indices not all being in sync together. With 32 months passing since the last 10%+ correction, the bearish camp is hoping that age alone will befall this market. History suggests otherwise.

Historically, major index non confirmation or divergence is typically a sign of a market about to correct or in the most extreme cases, the end of a bull market. This behavior was seen at the secular peaks in 2007 and 2000 as well as major peaks in 2011, 1998 and 1990. But before you jump to the bearish conclusion, it was also seen other times during bull markets that led to only minor (<10%) declines. The key factor in determining the seriousness of the warning sign is how many other flashing red lights are also active. Today, there are but a few.

In this case, as you know, I believe the bull market is aging, but not dead, and a 10%+ market correction is not around the corner, at least not yet. Rather, I have been waiting for either the major index warning signs to dissipate or many more to pop up and snare the stock market in a 4-8% pullback.

With the Nasdaq 100 and S&P 400 joining the Dow and S&P at new highs, only the Russell 2000 (seen below) is left to join the party. The reason I am not overly worried about the small caps lagging is because they have been leading the rally over the past week and very well could challenge their all time highs before long. A change in that performance over the coming weeks would cause me to expect a pullback but not much more.

rut

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Bear Trap and Dow 17,000

A week ago today, the major indices saw a solid red day that had the pundits talking correction and investors running for cover. One day later, however, the bulls closed the door on the bears, trapping them in some bad selling decisions. From there, the bulls had control right into the Memorial Day holiday and that should spill over early this week.

The Dow has already hit an all time high and the S&P 500 should be soon to follow. Even the Nasdaq 100 could get there before long, but the S&P 400 and Russell 2000 need a lot more help. That has been and remains a thorn in the intermediate-term health of the bull market.

Seasonal and volume trends create some headwinds after the holiday so it will be very instructive to see how the bulls behave on Tuesday and Wednesday. Further strength this week will bode well for a move above 17,000 next month while weakness should just be temporary or create a short-term trading range.

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Major Indices Not Singing a Good Tune

2014 may be young, but so far, it’s exhibiting a very different character than 2013 with the rate of ascent completely flat lining and the high flying leaders hit very hard. In other words, the year has been digesting as I wrote about in the 2014 Fearless Forecast. Don’t get me wrong, just because I forecast this type of action doesn’t mean it has been an easy year to make money. It hasn’t. And I don’t think that changes just yet.

I am going to discuss the five major U.S. indices and see what we can glean from the action in 2014. Remember, the healthiest markets have all five indices in sync, meaning they should all make highs at the same time.

The Dow Jones Industrials are first and you can see highs in March and April with essentially equal lows during the same months. After today, the Dow is within striking distance of all time highs, a positive sign.

The S&P saw a higher high in April than March, but a lower low as well, making it stronger and weaker than the Dow.

The S&P 400 Mid Cap Index is below and while it shows similarities to the S&P 500, it is now exhibiting a series of lower lows as seen twice in March and once in April. As such, it is also farther away from all time highs than the other two indices.

The Russell 2000 is next and here you can see a very different pattern. From the last significant low in 2012, this index has led the market higher almost the entire time through early March 2014. Since that time, we see a series of lower highs and much lower lows. Not only is the Russell no longer the leading index, but it’s action is anything but positive and certainly warning of something on the horizon. For full disclosure, some of our programs took a position here at the lows last week since it was overly stretched to the downside and the odds a short-term snapback.

The technology laden NASDAQ 100 is the last major index to show and looks very similar to the Russell 2000 except it has already retraced the entire February to early March rally. Neither index is anywhere near all time highs and both need to be watched closely.

The S&P 500 is next and the chart looks very similar, to the Dow above. If I were doing a full Canaries in the Coal Mine piece, the above comments would be collectively labeled a dead canary and certainly disconcerting for the long-term health of the bull market. However, the canary can certainly be revived if all major indices get back in gear to the upside later this quarter or over the summer.

In the short-term, contrary to what may be reported, it will not be a positive sign to see yet another high in the Dow and/or S&P 500 without the other major indices confirming that celebration. Until proven otherwise, the higher beta (read weaker) indices are now best viewed as sales into rallies than anything else.

Canaries Still Breathing Okay

I haven’t done a canaries in the coal mine update in a while, but with the major market indices hitting fresh highs last week, it’s time to check if any are dead. Remember, canaries in the coal mine are only useful at bull market peaks and bear market troughs. In other words, they are very helpful at spotting beginnings and endings of bull markets, but not much in between. They are so important because they usually give ample warning that a bull market is living on borrowed time as the canaries begin to die.

Let’s start with the major indices as they should all be in new high or fresh highs for 2013 territory. The Dow is first and you can see the all time from last week on the right side of the chart. 

dow

The S&P 500 (very large companies) is next and it, too, hit all time highs last week.

 s&p

The S&P 400 (medium size companies) is below and it is in line with the first two from above. The S&P 400 is usually the big leader during the mid stages of the bull market as many companies in this index experience their glory years or growth and financial stability.

mid 

The Russell 2000 (small companies) is next it saw all time highs last week. This has been the index leader since the June 24 low and pretty much entire bull market from 2009. There have been a few warning signs along the way, but they keep repairing themselves to health.

rut 

The technology laden NASDAQ 100 is the final major index and it has done a remarkable job at playing catch up, not only in the very short-term (since mid July) but also over the past year or so.

ndx 

In summary, all major stock market indices recently saw fresh highs indicating that the bull market is not close to ending. 

The Dow Jones Transportation Index is below and this serves two purposes. First, it’s a minor index after we look at the major ones. Second, old school Dow Theory offers that the Dow Industrials and Transports should be in sync during major rallies and declines to confirm the long-term trend. At bull market peaks like 2007 and 2000, we usually see one index fail to confirm the other’s price move. In other words, if this bull market were ending, we would either see the Industrials or Transports fail to make their final price peaks together. At this point, that’s not the case.

tran 

Turning to the bellwether sectors, the banks continue to lead and see new highs on each successive push higher in the stock market. This is healthy action. On a separate note as I mentioned on CNBC’s Closing Bell last week, the banks remain one of the most unloved sectors in the market in spite of their huge price gains and leadership role. I am not a fundamental researcher,  but if investors can look past the major players like J.P. Morgan, Citi and Wells Fargo where new government regulation may present some head winds, the regional banks and small banks may present some good opportunities, especially if a mergers and acquisitions wave begins.

banks 

With overall sentiment towards the banks negative, this group should continue its leadership role and be a good buy candidate after market declines.

The semiconductors present a much different picture. They are so vitally important because of their leadership in the technology sector and technology’s leadership in the overall stock market. The semis not only are a long-term canary, but also have some good predictive power for intermediate-term moves, something that would make a good article for the next issue.

 semis

I have to admit that this group can be a bit frustrating at times because it gives more warnings than any other canary and the only warning that really matters for the end of a bull market is the final one. As you can see below, the semis did NOT see fresh highs last week and their price is already creeping back into the range we saw during May and June. This is not good behavior and bears watching closely.

The New Stock Exchange cumulative advance/decline line is next. For newer readers, this simply represents the number of stocks that go up and down each day totaled over time. I have found it to be an excellent barometer of liquidity and overall market health even though its warnings can range from a few months to almost two years as we saw in the spring of 1998. Detractors will point to the number of non operating companies that litter the NYSE, but that’s exactly why I find this indicator so useful. Those non common stocks are typically closed end bond funds (CEFs) that are acutely sensitive to interest rates. The combination of common stocks and CEFs has proven to be a valuable long-term indicator when the major stock market indices march higher without the NYSE A/D line.

From the chart below, we see twin peaks in May and July, a very mild warning with price going much higher, but nothing that indicates impending doom. This is another canary that should be closely watched now.

NYAD2

Finally, let’s take a peak at high yield (junk) bonds as depicted by the PIMCO High Yield Fund. You can use any of the major funds or the ETFs. I just choose PIMCO because it is a very large fund with a long track record. Junk bonds are so important because they are acutely sensitive to ripples in the liquidity stream as well as the economy. They are at the bottom of the credit hierarchy and money typically flows out of the sector at the first sign of economic trouble or decrease in liquidity.

PHYDX 

You can see how the fund made its high in May and sold off dramatically into June. What is unusual is that this decline occurred without stocks cratering. In fact, high yield bonds saw more carnage than stocks. And as stocks vaulted higher in July and August, the high yield sector could barely muster a rally to get back half of what it lost. This canary appears to be dead for this cycle. If junk bonds rollover again and we the PIMCO fund in the mid 9.40s, I think that will spell at least some short-term trouble for stocks. 

In summary, the canaries are generally healthy with only one dead (high yield) and maybe two on heightened observation (semiconductors and NYSE A/D line). Before this bull market ends, I expect to see many more canaries on the dead list.

 If you would like to discuss how your portfolio is acting now or could behave if more canaries bit the dust, please contact me directly by hitting REPLY or calling the office at 203.389.3553.