2 Reasons Small-Caps Look Ripe for a Rally

Stocks have been all bark and no bite, stuck in a trading range -- but that could change

"If a pullback occurs ... bulls want to see support on the SPY come into play between $266.86 -- its 2017 close -- and the $270.43 level."
-- Monday Morning Outlook, May 14, 2018

"[M]arket participants are currently at the ready to accumulate stocks or cover short positions at the slightest hint of a pullback ... While bulls have the upper hand, the SPY has been directionally challenged since the breakout above the trendline connecting the January and March highs. When this breakout occurred on May 11, this trendline that is on the radar of many technicians was around $272, which is the site of Friday's close ... buyers of this breakout have yet to make money and could grow impatient if the SPY does not sustain a move above $272 in the coming days and weeks."
-- Monday Morning Outlook, May 29, 2018

Last week was reminiscent of the one before, with negative headlines on the political front generating a sell-off, but short-term support levels discussed in this commentary limiting the damage. For example, two weeks ago, stocks sold off in response to President Donald Trump canceling a planned summit with North Korea; now, indications are that this summit will go on as planned. The SPDR S&P 500 ETF Trust (SPY - 273.60) low that week was just above its close when the Fed raised rates in March, the upper boundary of a support zone I had discussed.

It was political uncertainty in Europe, combined with renewed fears of a trade war with our North American trading partners, that sparked selling last week, pushing the SPY to a fresh three-week low. This time the SPY's closing lowwas just above $266.86 -- its 2017 close -- and its 80-day moving average, the lower boundary of a support zone that I spelled out in the middle of last month.

Just like the prior week, buyers of a pullback were "at the ready" once again last week. In fact, a rally from Tuesday's low pushed the SPY to the upper boundary of the current three-week trading range by week's end. While the trendline connecting the January and March highs that technicians are highly focused on marked the low on the S&P 500 Index (SPX - 2,734.62) in last Tuesday's session,the SPY closed below this trendline, but rebounded swiftly.

Last week was full of market-moving headlines, with the beginning of the week loaded with the negative, and the back end of the week more positive -- from a stronger-than-expected employment number, to a coalition being formed in Italy's government, to President Trump receiving North Korea's "No. 2" in a meeting that was described by Trump himself as "progress."

However, as I alluded to recently, for those trading the broader S&P since the mid-May breakout, option premium sellers or those with a very short time frame have been the happiest, as the SPY and SPX have traded in a range. Last week was a microcosm of this range, with the total absolute daily moves adding up to 113.71 SPX points, but the SPX sporting a gain of only 13.29 points on the week.

But it has been the large-caps that have stalled. Anyone who bought the riskiest of names on the SPX trendline breakout in May is sitting with healthy profits, with the small-cap Russell 2000 Index (RUT - 1,647.98) notching a new all-time high last week, and the technology-heavy Nasdaq Composite (IXIC - 7,554.33) moving to its highest level in two months on Friday, and taking out the half-millennium 7,500 level that marked a high in late January.

With that said, whether it is the SPY, IXIC, or RUT, all come into the new trading week just below key resistance levels. For example, the IXIC's round 7,600 century mark is roughly 10% above its 2017 close and near the site of 2018's highest close.

The RUT, as I have observed many times, is an index that tends to pivot both short-term and long-term at both half-century and century marks. For most of this year, the 1,600 level acted as resistance while both the 1,450 and 1,500 areas acted as support on separate pullbacks in early February and April. The RUT comes into this week just below the 1,650 half-century mark, which marked last week's highs in both the Wednesday and Friday trading sessions.

When comparing U.S. equity exchange-traded funds (ETFs) such as the SPY, the iShares Russell 2000 ETF (IWM - 163.84), and the PowerShares QQQ Trust (QQQ - 172.74), the IWM looks the most bullish from the perspective of evaluating price action and short-covering potential on its components.

The IWM is the only one of the three that hit an all-time high last week, and total short interest on its components is higher than 88% of comparable readings during the past five years. Current total short interest on SPX component names is higher than 60% of the readings looking back five years, while total component short interest on the large-cap technology QQQ ETF is higher than only 3% of the daily readings going back over five years.

From a price action perspective, the QQQ is running neck-and-neck with the IWM, trading less than a percentage point below its all-time high and up more than 10% year-to-date. But the short-covering potential on its components is not as great as that of the IWM components.

With last Friday being the first of June, standard expiration of June options comes at the earliest possible date -- on June 15. That means we are within two weeks of standard expiration, implying strike prices with big open interest could prove influential as we move closer to expiration.

The SPY 275 strike stands out at the moment, given the huge call open interest relative to put open interest. This strike corresponds with SPX 2,750, which is important because half-century marks have historically been significant as pivot points and/or hesitation areas.

Digging deeper into this open interest, I found that most of it was bought to open. That would suggest that this strike could act as a magnet if approached anytime before expiration, as the sellers of those calls would likely buy more S&P futures to stay neutral as the option becomes more and more sensitive to the SPY's movement. That said, if the SPY were to remain stuck in neutral as we move closer to expiration day, and the 275-strike call options are less sensitive to SPY movement, any long S&P futures positions associated with these calls will slowly be sold, creating a slight headwind into expiration day.

Total open interest at the 270 strike is heavy for both calls and puts, and thus the SPY should tend to find stability around this strike from an options perspective. On the downside, the SPY 265 strike is put-heavy, with those options mostly bought to open. Therefore, if support at the 2017 close at $266.86 is broken at some point between now and expiration, accelerated selling related to this put open interest could hit the market, as those short the puts are forced to sell S&P futures to remain neutral.

On the heels of a strong employment number, small-caps hitting all-time highs, and the SPY taking out $272 again last week, equities remain set up to drift higher into the June 13 Federal Open Market Committee (FOMC) meeting. If indeed the first half of June proves bullish for stocks, I think short-term sentiment will again reflect optimism at the time of the FOMC meeting, at which time stocks may become vulnerable to a pullback or another period of choppiness if the Fed raises rates as expected.

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