U.S. stocks closed higher on the week again last week, once again being led by small-capitalization stocks as represented by the iShares Russell 2000 Index (ETF) (NYSEARCA:IWM), which now brought the five-week gain to more than 7%. While the bulls scored another week, broadly speaking, utility and consumer staples stocks took it on the chin on the back of another rally in bond yields (drop in bond prices).
From where I sit, the big news last week and what could lead to a spike in volatility in the near future was comments from Federal Open Markets Committee chairwoman Janet Yellen that in October the Federal Reserve will begin shrinking its $4.50 trillion balance sheet.
On the below chart of the S&P 500 I marked three important spots;
- End of quantitative easing (qe) 1 (around May 2010): S&P 500 drops about 15%
- End of quantitative easing (qe) 1 (around May 2011): S&P 500 drops about 20%
- Fed starts hiking interest rates (December 2015): S&P 500 drops about 15%
As is evident, over the past seven and a half years, stocks reacted negatively (if only for a short while) each time the Federal Reserve pulled part of the punch bowl. With last week’s announcement the Fed is pulling even more of the punch bowl, if only slowly so and if history is any guide, this too could lead the stock market to react with some volatility and a corrective phase.
It is important to note that each of the aforementioned pullbacks in the S&P 500 happened a few weeks delayed from the initial announcement of stimulus reduction.
Moving averages legend: red – 200 day, blue – 100 day, yellow – 50 day
The recent rally in the Russell 2000, i.e. the IWM ETF, was largely a function of the rise in interest rates as well as a bounce in energy stocks. What do interest rates have to do with the Russell 2000 you ask? Just like energy stocks, financial stocks with around 25%-30% are an important chunk of the Russell 2000 and when interest rates rise as they have in recent weeks, financial stocks tend to rally.
This recent rally in small-cap stocks has now pushed the IWM ETF to the upper end of it year-to-date trading range. At the bottom of the chart I added the yield of the 10 year U.S. Treasury Note. At this juncture in my eye or the Russell 2000 to move significantly higher it would require a breakout in bond yields. Small-cap stocks here look overbought, which is to say that chasing them higher from these levels offers bad reward-to-risk.
Moving averages legend: red – 200-day, blue – 100-day, yellow – 50-day
Conclusion
In summary, given last week’s news on the Fed’s plan to begin shrinking the balance sheet as well as the seasonal tendency to see a spike in volatility and a drop in the stock market at some point during the September/October period it remains my number one objective to buy some portfolio protection (with the CBOE Volatility Index, or VIX back below 10). While option traders could use this opportunity to buy some put options or put spreads in the S&P 500’s SPDR S&P 500 ETF Trust (NYSEARCA:SPY), stock investors/traders could consider taking some partial profits in near and intermediate term positions.
Check out Serge’s Trade of the Day for Sept. 25.
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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