This Chart Shows Where Small-Caps Could Find Support

We started last week without much hoopla, and it seemed as if the calm U.S. equity market would continue trudging along. But on Thursday, stocks experienced an uncommon move downward, and the S&P 500 Index (SPX - 2,582.30) dipped below its 20-day moving average for just the second time in the past two months. Despite this uncharacteristic short-term drop, the index finished the week just slightly below breakeven, and remained largely unscathed.

Some market participants have pointed to concerns about the U.S. government's ability to pass a tax reform plan and how it's affecting the markets. In fact, intraday selling did occur around midday on Thursday, when it was leaked that the Senate's tax reform plan called for the new 20% corporate tax rate to take effect as late as 2019. It's impossible to dismiss this as a concern -- but it's also important to remember that the market rallied toward the end of Thursday's session, after the Senate formally released its tax reform proposal.

Among other market-moving headlines, Saudi Arabia continued its anti-corruption campaign last week, detaining hundreds of the kingdom's elite citizens in a surprise wave of arrests. Saudi Arabia also accused Iran of committing an "act of war" on Monday following a missile launch from Yemen, before later in the week ordering all of its citizens to leave Lebanon amid accusations of Hezbollah involvement in the strike. Tensions in the Middle East appear to be escalating steadily, and should remain on our geopolitical radar.

It's always an impossible guessing game when trying to connect the dots between news items and market movements, so let's discuss some things we do know -- starting with price action. As evidenced by the below SPX chart, U.S. stocks remain in an extremely strong uptrend. All major moving averages are trending up, and the index remains above almost every single one of them.

Chart courtesy of StockCharts.com

One thing that's noticeable in the chart above is that the 14-day Relative Strength Index (RSI, in the upper pane) crossed back below 70, which is traditionally considered "overbought." In the past, this type of behavior marked short-term periods of consolidation or minimal pullbacks. This isn't necessarily a long-term bearish signal, but can be categorized as a risk to potential upside.

Without going through each chart individually, it's worth mentioning that the Dow Jones Industrial Average (DJIA - 23,422.21), Nasdaq Composite (IXIC - 6,750.94), and Nasdaq-100 Index (NDX - 6,309.07) all remain in strong trends, as well, and closed the week above their respective 20-day moving averages. While all is well on the technical front, let's take a look under the hood and see how different parts of the market are behaving.

Mid-cap and small-cap stocks have been underperforming the broad market for much of 2017, but during the months of September, we saw a rotation into these two segments, and they outperformed their large-cap counterparts. You can see in the chart below how the Russell 2000 Index (RUT - 1,475.27) became extremely overbought in early October as it traded near the round-number 1,500 level, and has underperformed since then. It has also been forming a bullish flag continuation pattern, with potential support emerging in the 1,450 area should its slide continue.

Chart courtesy of StockCharts.com

It's also interesting to see the rise in short interest on RUT component stocks. As you can see in the chart below, this figure is coming off a multi-year high that was made in August. If we see a continuation of these short sellers buying back their bearish positions, short-covering could add buying pressure to this index in the coming months.

There has been some talk lately about market breadth deteriorating. Breadth attempts to gauge the direction of the market by analyzing the number of companies advancing relative to the number declining. The below chart is in indicator that measures all of the advancing stocks minus the declining stocks at the New York Stock Exchange (NYSE). The net value from this calculation is taken each day, and added (if positive) or subtracted (if negative) from the cumulative value from the previous day. The chart below shows breadth made a lower high on Nov. 8 and declined last week, but I would need to see a further decline in breadth for this to be a major concern.

Chart courtesy of StockCharts.com

What I noticed about last week, more so than the decline in breadth, was a rotation among sectors. First, in the table on the left, let's look at the leading sectors on a year-to-date basis. Technology, healthcare, and basic materials lead the way, while energy, staples, and real estate have lagged. But during the last five days, it was almost the complete opposite. Real estate, energy, and utilities moved higher, while materials, industrials, and financials finished in negative territory.

So, what happened to financials last week? Well, the yield curve has continued to flatten, and the spread between the two-year U.S. Treasury bond and 10-year U.S. Treasury bond reached its lowest level in 10 years. A steep yield curve indicates that long-term rates are higher than short-term rates, because expectations are for inflation and economic activity to grow in the future, and interest rates will ostensibly increase with this growth.

When a yield curve begins to flatten, like it is doing now, there are some ripple effects. First, financial institutions generally make a lot of profit from steeper yield curves, as they borrow short-term and lend long-term. So, in this context, it's no wonder financials didn't react to well to the new low in the chart below.

The flattening of the yield curve can also have broader implications. If long-term rates ever dip below short-term rates, it's called an "inverted yield curve" -- which means that expectations for growth are so low that market participants are anticipating interest rates will need to be decreased in the long term to stimulate a struggling economy. This has historically not been good for the stock market, and the last time this happened was ahead of the financial crisis in 2007. The yield curve is not yet inverted or flat at this point, but it's something to keep an eye on.

Chart courtesy of StockCharts.com

With the long-term uptrend in place, many fundamental and economic indicators are showing positive signs. Valuations remain high, but have been high for quite some time. Corporate earnings remain positive, and are just below +6% year-over-year in the third quarter, with energy companies showing the biggest jump. Overall, almost three-quarters of companies are reporting results that are better than expectations.

This is accompanied by a slowly expanding economy, employment growth, and an inflation number that is right around the unofficial 2% target of the Federal Reserve. With this in mind, most market participants expect a rate hike at the December Federal Open Market Committee (FOMC) meeting.

Sentiment has been, and remains, a mixed bag. We aren't seeing euphoria, but we are seeing optimism creep into the market. For example, CBOE Volatility Index (VIX - 11.29) 20-day call volume is at its lowest level since January 2017. VIX calls profit when we see sharp increases in volatility, and have become popular equity hedges during the past several years. The fact that so few VIX calls are being purchased indicates some complacency. TD Ameritrade also tracks buying and selling by its retail customers, and their Retail Sentiment Survey is near an all-time high. (They began collecting this data in 2010, so it does have a limited history.)

On the other hand, several other major sentiment polls we track are not yet near the extreme optimism levels we've seen in the past. The National Association of Active Investment Managers (NAAIM) produces a survey that tracks overall equity exposure from investment managers. Exposure among this group is at a below-average reading of 56.16%, which is the lowest in a year and a half.

It will be important to continue looking for clues of a market slowdown, using a combination of technical, fundamental, and sentiment indicators. Currently, given the mixed clues from various sentiment indicators, an improving economy and fundamentals, and overall strong price action, the stock market outlook remains positive -- but, given the recently overbought status of the SPX, perhaps a consolidation or slight pullback is not out of the question. We will also be watching small-caps to see whether they can regain their leadership role from September, or will regress back to the underperformance they've experienced for much of 2017.

Now that earnings season is wrapping up, more attention will return to major economic indicators. This week should be an eventful one, as the October figures for Inflation, retail sales, new home sales, and building permits will be released.

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