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By HaleStewart March 22, 2015 8:43 am
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US Equity Market Review For the Week of March 16-20: Small and Mid-Caps Outperform, Edition

     Last week, both the small and mid-cap ETFs broke through upside resistance and printed new highs.  The IWCs were up 2.5% for the week, closing at 80.49 while the IJHs rose 4.5% and closed at 153.69.  This continues a trend that started in early October where the small and mid-cap sectors outperformed the mega-cap stocks.  However, while these developments give bulls hope, these advances face strong fundamental headwinds in the form of an already expensive market, a strong dollar hurting an already weaker international environment and, most importantly, declining earnings.  Therefore, I remain sanguine about major moves higher and believe the overall consolidation theme that I proposed last week still has merit.

     Let’s begin by looking at the small and mid-cap daily charts, starting with the IWCs:

The IWCs have been in an uptrend since early October.  Last week, prices broke through resistance at the upper 78 level, printing several strong price bars.  Underlying technicals supported this move higher with the MACD giving a buy signal and the RSI rising.  Most importantly, the MACD’s level indicates there is potential room to continue the advance.

     Next, let's look at the mid-caps:

Much of the same analysis applies to the IJHs, save for their resistance level being 152.

     Last week’s small and mid-cap advances fall into the broader story of these sectors outperforming the largest market segments since 4Q14:

The chart above compares the small, mid-cap and mega cap indexes performance for the past year.  Since early October, both the small and mid-cap segments have risen ~18% while the OEFs (the mega cap index) has risen ~12%.  Because larger companies have a larger percentage of their sales overseas, this smaller segment outperformance makes sense.

     This upward surge faces strong headwinds from three sources.  First, the market is expensive.  The NASDAQ PE is 23.52 and the S&P 500s is 20.52 – both of which are high by historical standards.  Secondly, market breadth is moving into overbought levels:

The top chart shows the percentage of NASDAQ stocks that are greater than their 50 day EMA.  Currently, the percentage is 67.9%.  Over the last year, these readings have topped out in the lower 70s, indicating NASDAQ market breadth is already nearing overbought levels.  The bottom chart shows the same numbers for the NYSE, with the current reading at 65%.  While this average's overbought market breadth is a little higher, coming in around 75, is is also close to over-bought.

     And finally, consider the earnings environment:

Falling oil prices, a soaring dollar and concern about weaker global demand have increasingly pessimistic analysts predicting Standard & Poor's 500 companies will see no earnings growth at all in the first quarter of 2015.

That would be the worst quarter for Standard & Poor's 500 earnings since the third quarter of 2009, not long after the United States emerged from its recession. Revenue for the first quarter is expected to be worse, forecast to decline 2.0 percent from a year ago, according to Thomson Reuters data.

The biggest drag is expected to be energy companies suffering from the oil price collapse, but analysts have dropped projections in almost every sector as the earnings reporting season has unfolded.

On Jan. 1, S&P 500 first-quarter earnings were forecast to rise 5.3 percent, including energy companies, and 10.5 percent excluding energy companies. On Thursday, that consensus forecast was flat from a year ago including the energy sector, and cut to 7.9 percent growth excluding energy.

This same phenomena has been reported by the Financial Times and Morningstar.  The earnings situation is the best argument against a strong upside move for one simple reason: earnings and share price direction are positively correlated; without strong earnings growth, share prices languish.  Period.

     To recap: last week was a good week for small and mid-cap stocks, with both of these indexes outperforming their larger brethren.  However, the upside of these moves is limited due to the already expensive levels of the market, the over-bought market depth and the weak earnings environment.    

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer  


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