U.S. stocks, largely speaking, closed flat for the week last Friday. Plenty of risk headlines, from political to geopolitical, continue to be thrown at this market yet the primary trajectory remains higher.
While I always want to respect both sides of the market, fighting a primary trend or prematurely calling tops and bottoms is a fool’s game and leads to losing portfolios. In that vein, although the broader U.S. stock indices have traded with a sluggish upward bias of late, underneath the surface, we have continued to see meaningful group and sector rotation, which is what is keeping a bid underneath the broader stock indices.
Sector Rotation Reigns
You see, over the years I have learned to divide the stock market into two general environments:
- A general risk-on/risk-off environment where correlation among stocks is high and the primary driver of market movements is a general appetite or avoidance of risky assets. This type of environment tends to take place around stock market lows or highs in any time frame (near intermediate- and longer-term), or around major news events.
- The second type of environment, and the one we currently find ourselves in, sees money flowing from one sector or group of stocks to another as investors allocate capital based on what they think will be the next group of stocks to outperform.
Before looking at the most recent group and sector rotation, here is a chart of the S&P 500 versus the CBOE Volatility Index, or VIX.
Note that the mouth of my hungry alligator chart — i.e. the spread between implied volatility and stocks — continues to widen. While this is no immediate-term call to dump all stocks and head for cover, it should serve as some perspective in the bigger picture as ultimately a mean-reversion move will take place that will see stocks tumble and fear spike. This holds particularly true after eight years into a cyclical bull market that arguably is long in the tooth.
To kick off the week, here are the top three things on my notepad today:
1. Quarter-End — This week we get quarter and first-half-2017 end. Fund managers may be forced to window dress their portfolios, i.e. chase tech and biotech stocks higher this week, which could keep the bid under the market. Any dramatic move to the contrary would in my eye be a warning sign.
2. Can the S&P 500 Top 2500? That remains a key question for the broader market, and the more we see group and sector rotation like we saw last week in biotech, the more this becomes a reasonable next upside target. I want to continue playing this rotation game until it stops working.
3. Transportation Stocks — This group of stocks as represented by the iShares Dow Jones Transport. Avg. (ETF) (NYSEARCA:IYT) continues to act well and is consolidating at the very upper end of the six-month trading range, thus threatening a breakout higher. If group and sector rotation can continue then a breakout in this segment looks increasingly likely.
A key component of the U.S. stock market as always are the small capitalization stocks as represented by the iShares Russell 2000 Index (ETF) (NYSEARCA:IWM). On the above chart, note that the IWM ETF, much like the transports, is consolidating at the upper end of its six-month trading range and through the lens of technical analysis is working on a bullish flag formation.
A daily close back above $142 may be the signal that a breakout toward $147-$148 is underway.
At the bottom of the chart I plotted a ratio chart of the IWM ETF divided by the SPDR S&P 500 ETF Trust (NYSEARCA:SPY). Note that while relative weakness of small caps persists, the chart is visibly coiling so that a breakout in the IWM ETF would also lead to a relative strength breakout.
A good part of the IWM ETF is financial and energy stocks, which is to say that should we see a breakout in small-cap land, then this would likely be the result of relative strength in both the financial and energy sector. Both sectors have been relative underperformers year to date.
In summary, while the coming few trading days rounding up the second quarter and the first half of the year may primarily be influenced by fund manager window dressing games, we could also see continued sector rotation as money flows into transportation and small cap stocks.
Check out Serge’s Trade of the Day for June 26.
Today’s Trading Landscape
To see a list of the companies reporting earnings today, click here.
For a list of this week’s economic reports due out, click here.
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