Trader Talk

The stock market's tone is changing, with some indicators pointing to a year-end selloff

Key Points
  • The S&P 500 and the small-cap Russell 2000 have diverged about 4 percentage points.
  • Two high-yield exchange traded funds that had been doing well this year are both down more than 1 percent this month.
  • There are some signs the market advance is becoming more selective.
Markets change tone as progress on tax reform slows

Another day, another down open. There's a different tone to the markets in the last week or so.

It started last Tuesday, when an initial rally faded into a hard sell-off mid-morning. The next five trading sessions generally opened down.

Peter Tchir of Academy Securities, checked off a short list of concerns. There is progress on tax reform "but the reality is it's not going to be as great as everyone hoped," he said. There are questions about what the flatter yield curve means. And the recent arrests of high-ranking Saudis in an anti-corruption initiative created uncertainty in the last week and a half.

"Buyers have become a little more discriminating, it's a little more of a seller's market," Tchir said.

The S&P is less than one percent from its historic high of early last week, but elsewhere the declines have been more notable.

The most significant is a wide divergence between the and the small-cap Russell 2000. Since the beginning of October, the Russell is down about 1.4 percent, while the S&P 500 is up almost 2.4 percent.

That is almost a four-percentage point divergence. The only other time this happened this year was August, when despair over the prospects for tax reform drove the Russell down almost 6 percent.

In another sign, two high-yield exchange traded funds (HYG and JNK) that had held up well this year are both down about 1.7 percent this month.

Some of this underperformance is clearly related to tax reform issues. The House has inserted provisions in its tax bills that limit the deductibility of corporate debt, which may limit the ability of companies to issue debt.

But high yield has always been a bit more than just a yield play, Matt Maley from Miller Tabak tells me: "High yield is also a proxy for people's willingness to take risk."

How worrisome is all this? There are some signs the market advance is becoming more selective. Lowry's, the oldest technical analysis service in the U.S., noted to clients that the share of stocks hitting new 52-week highs has been falling, from 16 percent on October 2 to 8.7 percent last week.

But the critical NYSE advance-decline line remained near new highs, though it has not advanced for the past month because of the weakness in small-caps.

For the moment, this weakness seems contained. Lowry's sought to assure investors, saying, "The current divergences [between small- and big-cap stocks] are short term and minimal, and could be erased in a broad-based one-day rally."

But it bears watching. Remember, one of the main reasons the market keeps holding up is that many investors are sitting on handsome profits. Many are boasting gains of 20 percent or more this year. Given those gains, most would naturally be reluctant to sell now, since you can sell in January not pay taxes for 16 months, and maybe get a tax cut to boot. It makes sense to stand pat.

However, if the markets start to slip notably, the need to preserve gains will trump any tax savings. And that could lead to a broader selloff.

Every old saw about the market has been wrong this year. "Sell in May and go away:" Wrong. "September is a weak month:" Wrong. "October is a weak month:" Wrong. "November is a strong month:" The jury is still out on that one.