The European and U.S. equity markets rebounded today in anticipation of future central bank dovishness. The Federal Open Market Committee (FOMC) has signaled that it is potentially looking to cut interest rates as early as this month, and the European Central Bank (ECB) announced at its monetary policy meeting today that it expects key ECB interest rates to remain at their present levels at least through the first half of 2020.”
Traders are buying large-cap stocks in anticipation that low rates could both stimulate the economy and make it cheaper for large corporations to continue funding their share buyback programs with more debt. They are also anticipating that low rates and economic expansion could spur demand for crude oil.
Crude oil can be a great indicator for anticipated economic strength. Oil prices tend to climb when traders expect the economy to get stronger, and they tend to fall when traders expect the economy to get weaker.
Crude oil bounced back above $53 per barrel today after having dropped as low as $50.60 per barrel yesterday. This bounce brings crude oil back up to retest the uptrending price level that served as support for the left and right shoulders of the inverse head and shoulders pattern the commodity formed at the beginning of the year. If oil can break back up above this level, it has a good chance of climbing back up toward $58 per barrel.
Today's bounce in crude oil helped the energy sector lead the way higher on Wall Street. Apache Corporation (APA) rose 2.85%, Occidental Petroleum Corporation (OXY) jumped 3.39%, and TechnipFMC plc (FTI) soared 4.10% higher.
The S&P 500 continued its bullish recovery today by invalidating the head and shoulders bearish reversal pattern the index completed on May 29. A head and shoulders pattern is invalidated when the index, or stock, climbs back up above the price level that served as the neckline of the reversal pattern. In the case of the latest pattern on the S&P 500, the neckline was the uptrending level that was formed by connecting the lows of the dips in late March and early May.
Seeing this bearish reversal pattern invalidated is an encouraging sign for the S&P 500. Often, when a head and shoulders pattern fails, it signals that there is more bullishness ahead. With the S&P 500 now back above the key level of 2816.94, I wouldn't be surprised to see it continue climbing toward 2,900.
Risk Indicators – Struggling Small Caps
While the S&P 500 (SPX) is rallying, the Russell 2000 (RUT) – my favorite small-cap stock index – is struggling to keep up. In fact, the Russell 2000 failed to gain any ground today, dropping 0.22% to close at 1,503.538.
So why is this important? Small-cap stocks – like those in the RUT – tend to outperform when traders are confident in the global economic outlook and are willing to take on more risk in the hope of achieving a greater return. On the other hand, large-cap stocks – like those in the SPX – tend to outperform when traders are less confident that the global economy is going to remain strong and aren't willing to take on as much risk.
I like to keep an eye on which segment of stocks is outperforming by creating a relative strength chart between the RUT and the SPX. The RUT/SPX relative strength chart illustrates these shifts in sentiment by moving higher when small-cap stocks are outperforming and moving lower when large-cap stocks are outperforming.
Today, the RUT/SPX broke through key support to its lowest level since March 2016 as the SPX broke higher while the RUT languished. This tells me that, while traders are excited about the potential bullish impact an interest rate cut by the FOMC could have on blue-chip companies, they are nervous about taking on too much risk.
Small-cap stocks are typically considered to be riskier investments, but they are even riskier now thanks to the Trump administration's tariff threats against Mexico. These tariffs, if implemented, would have a direct negative impact on the U.S. economy, and most small-cap stocks only do business domestically in the United States. They don't have the luxury of generating revenue overseas where tariffs on Mexican goods won't be directly felt.
Bottom Line - Pick Your Battles
Traders have shown this week that they are still hoping for growth in the near term. However, we are definitely not in a "rising tide floats all boats" situation on Wall Street. You are going to have to pick your battles wisely. There are plenty of stocks that are doing well. Watch out for those that have already established new downtrends.
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