As we discussed in last week’s update, the market’s fear index — the VIX (INDEXCBOE:VIX) — is at an important inflection point. In our view, the most likely outcome is sideways trading, which is where our outlook continues to be focused on the short term.
Volatility since last Wednesday has been high, but there haven’t been any significant support levels broken and the underlying fundamentals remain stable.
Part of the reason we continue to feel confident is based on the reaction to the Federal Reserve Chair Jerome Powell’s comments to Congress on Tuesday. Although full of dire warnings, Powell’s statement is being interpreted as putting pressure on lawmakers to get another big round of stimulus passed. Whether that comes to fruition or not is uncertain, but investors see that as a positive.
Because we are in between earnings reporting seasons and there isn’t a lot of additional economic data due this week, investors will likely continue to push stock prices back and forth in a fairly wide range. This is a good time to evaluate intra- and intermarket data to see if we can detect any signs of positive (or negative) momentum.
We can’t let a weekly update go by without taking a look at the tech sector, which has been one of our favorites this year. The selling earlier this week was largely focused on tech, including Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT), which makes sense when valuations are considered.
While it is true that tech is a little overvalued, the proportion of profits from that sector, compared to the S&P 500 as a whole, helps justify those values. In fact, tech has the largest positive difference between its profit margins and the average profit margin in the S&P 500 — 19.2% vs. 10.8%, respectively — which is a metric we monitor for signs of weakness.
As we have mentioned many times in the past, transportation stocks are an important confirming indicator for the market. If transports are hitting new highs, we see that as a sign of strength for the major indexes.
As you can see in the following chart, although transports have pulled back this week, the Dow Jones Transportation Average has broken resistance and new highs, which should be seen as confirmation that retail and business spending is still relatively stable.
Daily Chart of the Dow Jones Transportation Average (DTX) — Chart Source: TradingView
Although it is good to see the sector performing so well, we have to temper our enthusiasm a little because of the amount the index is influenced by United Parcel Service (NYSE:UPS) and FedEx (NYSE:FDX), which make up a large portion of the gains for the group.
We have to assume that demand for this kind of shipping could shift very quickly if consumer incomes (or unemployment benefits) drop.
As a rule, investors look at small-cap stocks (companies worth less than $2 billion) in a similar way to transportation stocks. If small caps are gaining (and even outperforming) on large caps (stocks worth more than $10 billion), then it is solid confirmation of bullish momentum because small stocks are riskier so investors must be more confident.
This has been a weak spot for the market over the last several weeks. As you can see in the following chart, not only have small caps — as represented by the iShares Russell 2000 ETF (NYSEARCA:IWM) — been underperforming, but as of Tuesday’s close, they are trading under June’s highs.
Daily Chart of iShares Russell 2000 Versus the Rydex Equal-Weight S&P 500 Index — Chart Source: TradingView
The underperformance of small caps can be partially explained by the concentration of the biggest and most profitable tech stocks in the large-cap indexes. If we neutralize stocks like AAPL and MSFT with an equal-weight version of the S&P 500 then the comparison starts to look a bit more normal. In the chart, we have used the Rydex Equal-Weight S&P 500 ETF (NYSEARCA:RSP) with the IWM ETF to make this comparison.
We have to be careful when making a comparison like this; it can lead to cherry-picking the data that supports our bias and ignoring data that doesn’t. In this case, we think this is a fair comparison because of the unusual impact the big tech stocks have had on the major large-cap indexes this year.
If the bulls are truly gaining control (or are already in control) we would expect safe-haven investments to be moving lower. This includes U.S. Treasury bonds, Gold and safe-haven currencies such as the Swiss Franc and Japanese Yen.
As you can see in the following comparison, this is probably the biggest “yellow flag” we have in the market. Demand for U.S. stocks has been good, but global demand for safe-havens remains relatively stable without giving up many of the gains over the summer.
Daily Chart of Treasury Bonds Versus the Japanese Yen and the Swiss Franc — Chart Source: TradingView
Although this isn’t a new development, strong safe havens are the best technical justification for maintaining a cautious outlook.
In fact, this week we have scaled back a little on our bullish positions by taking profits on Target (NYSE:TGT) and Nike (NYSE:NKE) and increased our bearish exposure a little with a new short position on Hess Corporation (NYSE:HES). We don’t plan to shift to an entirely bearish portfolio this month, but right now we think the timing is good to increase the balance in the current list of recommendations.
Bottom Line on This Week’s Volatility
As we already mentioned, there aren’t many economic reports this week that we expect to move the market very much. There is a small trickle of early earnings reports, but the biggest X-factor is likely to be progress (or the lack thereof) for more stimulus.
Despite Powell’s urging, we feel that the fight over President Trump’s ability to appoint a new justice to the U.S. Supreme Court, following the sad passing of Justice Ginsburg, will harden the negotiating position of both sides.
If we are correct about gridlock in Washington, then there is a good chance the market is overpricing the potential for stimulus and could be setting itself up for a negative surprise to the downside.
This particular source of uncertainty is unlikely to be resolved in September, which should keep stocks range-bound and volatile as we head into October. While that isn’t the ideal outcome for us, the bright side is that option premiums are higher than normal, so our income potential has been increased.
On the date of publication, John Jagerson & Wade Hansen did not hold (either directly or indirectly) any positions in the securities mentioned in this article.
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it.