Article / 22 May 2014 at 13:09 GMT

US Stocks: Watch small caps versus large caps

Trader /
United States
• US markets to close on Monday for Memorial Day
• Small cap stocks underperforming
• Retail stocks under pressure

So far, it has been another choppy week for stocks, which is to say that dips continue to be bought while rallies get sold. As I discussed on Monday: "just as the broader investment community has been conditioned to blindly buy every dip, the 'strategy' becomes much more difficult to implement, i.e. the path of maximum frustration becomes clear".

The going for the rest of the week is unlikely to get much easier, either, as US markets this following Monday will be closed in observation of Memorial Day. In other words, I expect things to dramatically slow down ahead of the three-day weekend as many market participants will be skipping out early on Friday.

In the bigger picture, I still expect one more rally in large cap stocks over the coming weeks before calling a top in this latest cyclical bull market. Nonetheless, I will, once more, point to the chart below of the S&P 500 (blue line) and the Russell 2000 (red line). The recent under-performance in small caps (Russell 2000) is clearly visible. While this can continue for another few weeks or months, the longer it lasts the more it limits the upside for large cap stocks. It's a simple but straightforward way of gauging the direction of the overall US equity market. Tops in broader equity indices are rarely events but rather are processes that take time to work through. Many times an up-trend first turns into a excruciating sideways move (like we currently have), before turning down.

S&P 500 vs Russell 2000
Source: esignal

The Dow Jones Industrial Average (DJI.I), after handing the bulls a momentary headfake breakout move last week, on Wednesday, staged its best one-day rally in at least a couple of weeks. The day resulted in a bullish outside (engulfing) candle on the daily chart, and also meant that the index held its late February up-trend. While that's nice to see, the index remains stuck right in the middle of its multi-week range. That smells of a weak risk/reward environment, at least until the index can build a better base to push higher from. Sitting on one's hands here until the fog clears is likely to be the best risk management strategy.

Dow Jones Industrial Average
Source: Saxo Bank

Meanwhile, the earnings season for many US retailers is underway and we have already seen some funky moves in retail stocks already, in reaction to the reports. Many retailer stocks have come under pressure recently but the stock price of high-end fashion retailer Nordstrom Inc (JWN:xnys) last week blasted higher after the company showed great year-over-year sales growth in a difficult environment. The stock now needs to consolidate the post-earnings rally, but after some stabilisation this will be a stock to watch closely as its relative outperformance is likely to continue, particularly if and when the broader market can stage one more leg up over the coming weeks and months.

Nordstrom Inc
Source: Saxo Bank

Serge Berger, an active trader since 1998, is a leading specialist in Trend Following. Read more of his regular commentary on our social trading site here.

-- Edited by Kevin McIndoe


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