I have strong views when it comes to markets. One of my strongest views is that we should never rationalize an indicator. Trying to rationalize a move is essentially to ignore the message it might be telling us: Indicators act how they act for a reason.
This doesn’t mean that all rationalizations are wrong, but rationalize once and you find it easier and easier to rationalize every single time and the next thing you know you’re spending more time rationalizing than you are paying close attention to what the indicators are telling you.
I bring this up because in the last two days of trading, I saw a lot of rationalizing as to why the small caps have acted so poorly relative to large caps. The last month has been particularly brutal for this relationship, yet many have opted to ignore it — until Friday.
I don’t know why it was that Thursday and Friday, so many felt compelled to rationalize why this has been so bad. The reasons I heard are plenty: Small caps don’t buy back stock, money is flowing into large caps, small caps have too much debt, small caps don’t make any money, or you don’t need small caps to have a good rally. Then there was my favorite: All the good small caps have grown up so they are mid-caps now.
This one was my favorite because have you seen what the mid-caps look like relative to the big caps? Look at the fund for mid-caps (SPDR S&P MidCap 400 exchange-traded fund (MDY) ) relative to the the one for the S&P 500 (SPDR S&P 500 ETF Trust (SPY) )?
Heck, the Russell 2000 (iShares Russell 2000 Index (IWM) ) is a champ in comparison.
No, this is not about small caps, this is all about the stocks that move the big cap indexes. I saw where the Top 5 stocks in the S&P account for 17% of the index.
In my experience, what we’re seeing in small- and mid-caps tends to reflect what is happening in the majority of stocks. And when the troops — the majority of stocks — are diverging from the Top 5 generals, it is only a matter of time before something shifts.
Along those lines, look at the breadth using common stocks only. It pretty much peaked three weeks ago.
The McClellan Summation Index we have discussed almost daily. It has flattened out. It has not yet rolled over, but flattening out pretty much mirrors what the cumulative breadth chart above says. The troops have stopped participating. If it rolls over, it means they are retreating.
The 10-day moving average of new highs on Nasdaq has shown very little in the way of improvement in 2020 and the new lows have increased marginally, but not enough to turn the 10-day moving average back up.
But over on the New York Stock Exchange, the number of stocks making new lows increased last week, albeit only to 20, but it was enough to turn the 10-day moving average of new lows up for the first time since early November.
The way I see it the market has three paths it can take: On the one path, the small caps get oversold enough to rally again; on the second, the whole market corrects enough to reset the indicators; or, on the third, we keep heading down the path we’ve been on, with a narrow group of stocks dragging up the indexes, while the majority of stocks meander or go down.
The second option is the most healthy, because resetting the indicators and shaking out complacency is always what cures the market. Option three is the most bearish, because divergences that go on too long, especially ones that are rationalized, tend to result in much more severe corrections than anyone is ready for, even those who are looking for it.
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