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By: Bill Spencer — May 16, 2020

Small-Cap Saturday - These 2 ETFs Tell Us A Lot About the Market

Hello!

Welcome, and thanks as always for stopping by.

As part of our continuing (and heroic) effort to "flatten the curve", all "Small-Cap Saturday" readers must be wearing masks.

And please remain at least six feet from your screen.

Remember: We're all in this together, unless we're sitting in cash.

All kidding aside...

Today we're going to look at the market from a variety of angles. We'll look at the "external" market, the internal market...

And then we'll look at how a couple of our recent trade ideas are faring and see what that tells us about the state of play in the stock market.

Now then...

As you know, the market has rebounded impressively since the March 23rd low.

Here's how the major market averages performed from that date through May 8th.

(Click any image to enlarge)

("Rut" and "SML" are, respectively, the Russell 2000 and the S&P 600, are two small-cap proxies.)

Like I said... impressive.

So it was only natural that people got agitated earlier this week when the market sold off.

Over the two-day span from Tuesday May 12th through Wednesday May 13th, the Dow Jones fell 1,044 points (-4.30%).

And if you watched the mid-week financial news you heard a drumbeat of downbeat speculation. Everything from Dr. Fauci's warnings about more "suffering and death" if states reopen their economies too quickly...

To Fed Chairman Jerome Powell's caution that economic recovery could by slower than expected.

By week's end the Dow had recovered about 40% of that loss. And the full-week performance of at the major averages, while weak, was far from unprecedented.

That's not to say there aren't troubling signs. There are...

We're seeing a reversal of recent small-cap strength, which could foreshadow a shift in sentiment from "risk on" to "risk off".

Also, on Wednesday May 13th, our main indicator and risk barometer, the New York Stock Exchange Bullish Percent Index (NYSE BPI) made a significant move.

After spending 36 days in a column of X's... it flipped into a column of O's.

Here is the NYSE BPI shown in "point and figure (P&F) style. The newest O's column is shown highlighted at the far right.

If you're unfamiliar with P&F charts, don't worry. I'll explain the key points now.

The NYSE BPI shows us what percentage of stocks trading on the NYSE are currently on point and figure "Buy" signals on their respective price charts.

Right now 39.98% of NYSE stocks are on "Buy" signals (the red arrow at the top). Before the chart flipped from X's to O's, that number was closer to 56%.

There are 2,800 stocks that trade on the NYSE. So over the past week we saw the number of stocks on Buy signals fall from about 1,568 to about 1,120 -- a decrease of 448, or -28.6%.

Said another way, we saw the number of stocks on sell signals increase by 448 (net).

That's key, because a stock only goes on a sell signal when its price falls below key technical support levels -- levels where, historically, buyers (bulls) could be counted on to come in and drive the price higher.

For the stock's price to pierce that level there has to be  tremendous amount of selling by large institutions. Now take that scenario and multiply it by 448 stocks.

That the NYSE BPI is in an O's column is a sign that the market is weak over the short term. The BPI chart itself is still on a Buy signal (point and figure charts are always on either a Buy signal or a Sell signal at any given point in time; there's no in-between condition).

We won't be able to say that the market is weak over the long term until the chart goes on a Sell signal. And that won't happen until and if the current O's column falls below the previous O's column. I've marked that box with a red arrow, at the right of the chart.

If that happens, the chart will enter the "oversold" region and the market will begin approaching a "washed out" condition.

Will that happen? We'll know soon enough.

But there is one sign that it might not.

The NYSE %30 Week chart (pronounced 'percent 30 week') is another indicator you should get to know.

It shows what percentage of stocks on the NYSE currently trade above their 30-week Moving Average (MA).

This chart tends to lead the BPI chart. Its moves tend to happen ahead of a similar move in the slower-moving BPI.

As you can see, the %30 Week is currently in a column of X's.

What's more, if it fills one more box in the current X column (the blue arrow) the chart will go on a "Buy" signal.

The point is that the odds favor a return to short-term strength in the market.

Now, one of the pitfalls of punditry is that your view of things tends to be "from the stands". It can get to theoretical and sort of detached from real trades and real results that exist out there "on the court".

In recent weeks we talked about two trade ideas in this weekend forum.

How have those plays panned out so far? And can that tell us anything about the state of play in the market?

On April 19th ("Let's Get Bearish on Housing") we looked at the crisis in the residential mortgage space.

I wrote at the time "If you want to channel your inner Michael Burry and gain bearish exposure to this space, consider buying a Put option on [the iShares Mortgage Real Estate Capped ETF (REM)].

With REM trading at $21.17 I recommended buying the October 30 Strike Put option for $10.70.

As of yesterday's (Friday's) close REM was at $20.39, down -3.68% in a month. Our Put option was worth $11.25 - up +5.14% or 67% annualized.

So our trade is working out so far. And if REM falls to $18.75 in three weeks (down an additional -8%) our Put will be worth $12.54 and we will have made 17%, or 127% annualized.

That said, REM has not fallen as precipitously as market conditions back on April 19th might have suggested. And while housing is not out of the woods yet, we might not be headed for anything like the kind of crash we saw in 2008.

That's good news for the economy.

Just last week ("Did the Fed Just Hand Us a Quick 111%?") we looked at the Federal Reserve's historic plan to buy up not just corporate debt, but junk bonds and certain qualified ETFs as well.

The idea was to not "fight the Fed", but to instead get in on one of the ETFs that were likely to appear on the central bank's shopping list.

I recommended buying the iShares iBoxx $ High Yield Corporate Bond ETF (HYG).

I also said you should consider buying the November 74 Strike Call option for $6.60.

This past Tuesday the Fed made good on its promise. Through its new Secondary Market Corporate Credit Facility the central bank began buying ETFs, taking in $305 million in its first day of operations.

The program is brand new of course. And its full scope and impact remains to be seen. (The Fed has not revealed which ETFs it purchased, but it says it will do so monthly.)

Not everyone is impressed with the Fed's effort. On Friday The Financial Post featured this unpromising headline: "Fed Corporate Bond Program Starts With a Fizzle".

As for our position in HYG, as of yesterday's close the ETF was down -1.30%. Our Call option is trading at $5.92 -- down 10%.

Again, the Fed's program has yet to take flight, so I expect our trade to pan out.

The point here is that the Fed is not rushing into the ETF market. There's little of the "five-alarm-fire" feeling we had in March when the Fed announced the program.

Again this could bode well for the economy and the market.

And of course we'd do well to keep a very close eye on all of these developments.

Stay Safe and Sane, and I hope we're all out of houses and out on the town very soon!

See you next weekend,

Bill Spencer

Editor-in-Chief, True Market Insiders

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