Eye On the Markets: August 18th
The Russell 2000, the index that tracks the best-performing small-capitalization stocks, is now within ten points of its June closing highs. At one point early Friday it actually surpassed this level briefly before pulling back. While an inordinate amount of time has been spent by analysts to explain the enduring crisis in the financial sector, the rising and now declining price of oil, the performance of the smallest stocks in the market as a typical leadership indicator has only recently begun to receive any air-time.
In a classic market sense, the small-caps represent the most economically sensitive category of company, and therefore decline in anticipation of major trouble and rise in advance of an improvement in the macro picture. Last year the small-cap indices - both the Russell 2000 and the S&P 600 - led the market into decline, outpacing their larger peers. Now they are threatening to carry the torch out of the doldrums.
How noteworthy is this development? Moving above the June highs would be significant, although if history is any guide it will take awhile for sentiment to catch up to the parade, which could be a good thing. Few market watchers have given enough commentary to the fact that while the S&P 500 and Dow Jones set fresh market lows in July, neither the Russell 2000, the Nasdaq Composite nor the Nasdaq 100 confirmed with new lows of their own.
From a technical perspective, now that they have set "higher lows," successful closes above their June highs would complete the "higher high" pattern and suggest intermediate-term changes of trend. Given that we haven't seen this since the mid-year market correction of 2005, this would be an encouraging development. Note that on a weekly time frame, the Russell 2000 has already accomplished this feat. It seems likely that it is only a matter of time before it is confirmed on all time frames.
The Nasdaq Composite and Nasdaq 100 have more work to do to complete similar patterns. Ultimately the small-caps will need confirmation from their larger cousins or the indicator could serve merely as a false lead. According to Bespoke Investment Group, the small-caps have successfully rallied at many of the most recent market bottoms (1999 and 2002). However they have also rallied at brief intervals during major bear declines. These failures amount to valiant but unsuccessful "fits and starts" and could prove dangerous should investors jump aboard at the wrong time.
So which is it? There are a lot of headwinds currently, and several notable potential problems. First off, and most obviously, could be the current military conflict between Russia and Georgia. The sooner this is resolved and Russia is placed back in the "penalty box" the more likely it will serve as a non-factor. If it were to escalate, or the word from the battlefield to ring true that Russia has indeed been making bombing attempts on the Baku pipeline, well then we could be in for some fireworks, especially with the price of oil.
Oil and gold are both long overdue for some kind of "pity bounce." As we have noted for the past several weeks, the fact that there are still many pundits calling for a rabid return to high prices, despite proof from the Eurozone of impending economic trouble, we are probably going to see the price of oil go much lower than anyone expects. Now, Russia is the wild-card in that equation. But so far the market seems unimpressed.
One reason for this is the U.S. Dollar. As we have noted week-in and week-out, this dollar rally is for real. How can we be so certain? Firstly, dollar rallies and declines tend to have long lifespans. The reason for this is simple: the fundamental dynamics driving changes in trend are hard to machinate and even harder to reverse. As the economic snowball begins to build steam in Europe, the Euro will continue to come under pressure, adding fuel to the dollar's rise. For proof of what kind of momentum we are seeing, take a look at the chart for long-duration treasuries. Despite an immense amount of fresh supply coming online, treasuries continue to rally. So either the market does not believe the inflation data coming out - and perhaps there is reason to believe it is overblown, given global weakness mounting - or foreign central banks are buying treasuries hand over fist. Or both.
Honestly, this author would have thought long duration treasuries to be the ultimate short sale, but when an instrument rallies when it shouldn't, there is something powerful at work on the other side of the trade. In this case, renewed interest in treasuries is a sign of strength in the U.S. Dollar, and a feeling that the U.S. is the safe haven once again, despite the worst CPI data in over 17 years.
The number of challenges for the financial industry are widespread and do not need to be re-covered here. However, increased speculation around the imminent nationalization of Freddie Mac and Fannie Mae could serve as the catalyst for a needed test for financial sector stocks. Should oil, natural gas, and gold get the long overdue bounce in the days ahead, we could see a retracement in financials, as well as the current market leadership, namely medical and health-care stocks. The U.S. dollar has also gone straight up in the past few weeks, suggesting that it too could stall here after breaking key resistance, consolidate or even pullback before mounting another move higher. The fact that it has logged a higher high however suggests again that pullbacks should be bought, not sold - a gameplan that should be replicated with stock positions unless this dynamic somehow fails and reverses course.
It would not surprise us if these corrections occurred sooner than later. The correction could also prove to be deeper and scarier than one might expect early in a rally. However, this should serve to successfully shake out the weak hands. Recent buyers need to be convinced they made the wrong decision before the market can attempt a meaningful run at the June highs.
The S&P 500 and Dow Jones, while participating in this rally, are only doing so tepidly. They continue to trace out "rising wedge" patterns which are weak flag formations suggestive of a drying out of buying interest. The Nasdaq previously sported a similar pattern, but punched out of it. Time will tell what happens with these laggard indices, but there is no reason to believe they are going to suddenly turn bullish, not with the two-pronged, schizophrenic constituency of energy and financials making up such a large part of their composition.
Another sign that this rally is running out of steam at least in the short-term: there have been numerous breakdowns in new leadership. This sort of cannibalization does not bode well for the resiliency of the rally. Those wishing to place bets on a market recovery into the latter half of the year may wish to wait for a sharp pullback on light volume to initiate new positions. Small-caps obviously should be the place to look for performance.
On a side note, we wish to thank Wikinvest for their making their stock charts embeddable. By clicking on the "enlarge" link viewers of this blog can see the details of particular annotations (color-coded). Viewers can also click directly on the colored box within the chart to see annotations. This is a useful tool and their web site is worth a look.
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