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Chart Advisor | Focus on the Price

By Gordon Scott, CMT

Friday, July 10, 2020

1. Investors position themselves for opportunity

2. Where Technology sector goes, the market will follow

3. Warning signs will show up in small cap stocks

Market Moves

Stocks closed the week on a high note as the S&P 500 (SPX) added one percent to its total today. Both the Dow Jones Industrial Average (DJI) and the Russell 2000 index (RUT) did even better. The implication is clear: investors expect earnings season to bring good news and they have positioned themselves for opportunity.

The chart below compares the movement of several index-based exchange-traded funds (ETFs), each of which focus on a particular asset class. Invesco's Nasdaq 100 index ETF (QQQ) tops the list for the last two months, followed by State Street's S&P 500 Growth index fund (SPYG), and iShares Russell 2000 index fund (IWM).

In last place among this group is the S&P 500 Value ETF (SPYV). This fund holds companies that pay good dividends and have strong and long-running business operations. Examples include Johnson and Johnson (JNJ) and Verizon (VZ). The notion behind constructing such funds is that these companies represent a solid value that is sure to perform well over time without requiring investors to take unnecessary risk along the way.

So what does it say when investors are brushing aside such instruments? It says that today's investors are seeking opportunity to an unusually strong degree--more so than in the past several years. This condition is usually a dangerous thing, but historically it is easy to demonstrate that markets can continue in this state for a long time. As one point of reference, the market doubled over the three years AFTER Alan Greenspan made his famous remark about "irrational exuberance" at the end of 1996.

Where Technology Sector Goes, the Market Will Follow
When markets simply keep going higher, it is useful to keep an eye on the leading sector driving indexes upward. For now, that is the technology sector. The market won't continue going higher if this sector takes a turn for the worse.

The chart below compares both QQQ and iShares' Russell Microcap stock index ETF (IWC) with three stocks within this sector that investors will want to keep an eye on. If any of them shows weakness during the next three weeks of earnings season, it will likely indicate a coming change of trend for the overall market in the days and weeks following that signal. Amazon (AMZN), Nvidia (NVDA), and Twilio (TWLO) are all riding higher right now. If any of them stops hitting new highs along the way, chart watchers should take notice and act accordingly.

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Warning Signs Will Show in Small Caps

It is important to keep an eye on small cap stocks this season. If investors are enthused about risking money for higher returns in the stock market, then this asset class should be attractive to investors right now. However, this grouping has lagged behind the more well-known names in the market.

The chart below compares the Russell 2000 index (RUT) with the CBOE Small Cap volatility index (RVX). Interestingly, this index is making higher lows even while RUT is doing the same thing. That is usually a bearish signal.

If small cap traders sense trouble ahead, then some stocks within the index may soon change trend before the others in the index. Three strong stocks within this index that are likely to show early signs of trouble in the event of a market correction are shown on the right side of the chart below: Etsy (ETSY), Zynga (ZNGA), and Chegg Incorporated (CHGG).

The Bottom Line

Stocks finished the week on new highs signaling clearly that investors are willing to place their money in more risky opportunities because they expect good news to come from earnings. The tech sector and small-cap stocks might be good candidates for traders to find signs that investors are growing less optimistic along the way.