Small-cap stocks clearing a key hurdle.

Following an extended period of decelerating inflation reports, both consumer and producer price indexes came in hotter than expected for the month of January.

First up was the Consumer Price Index (CPI), with the headline figure increasing 3.1% in January. That compares to expectations for a 2.9% gain, while the more recent six month annualized pace of the stickier core measure ticked up to 3.7%.

Meanwhile, the Producer Price Index (PPI) came in at just 0.9% on the headline figure compared to last year. But its core measure rose by 2.0% and was higher than the 1.8% expected. The chart below shows the year-over-year core measures for both CPI (red line) and PPI (blue line).

Along with ongoing strong jobs figures, the inflation reports are leading to further delays in the timing of the first interest rate cut by the Federal Reserve. Back at the start of the year, market-implied odds were looking for a rate cut as soon as next month.

The timing of the first cut is now being pushed back to June, while the number of 0.25% interest rate cuts in 2024 is dialed back to four (table below) from as many as six earlier this year.

With the rate outlook becoming more cloudy, the S&P 500 ultimately finished the week lower following several volatile sessions. It was the first weekly loss for the index since early January.

Regardless of the S&P’s reaction to inflation reports, I’ve noted recently that extended momentum is increasing the risk for a mean-reverting move lower in the indexes.

But despite the weaker price performance in the S&P, the action in other corners of the market are proving to be encouraging.

Last week, I discussed how a key intermediate-term measure of momentum was becoming extended for the S&P 500. That’s increasing the potential for a mean-reverting move lower in the index.

That doesn’t mean the bull market has run its course. Rather, a partial retracement of the gains or period sideways trading (a correction in time) would help consolidate the gains and set the stage for the next leg higher.

The chart below is the weekly chart of the S&P 500 since late 2022, along with the MACD indicator. You can see that gains since 2023 came in two distinct waves from March through July and then from October to current. Each wave followed a MACD reset at the zero line, with the MACD becoming extended once again.

It’s easy to be lulled into a sense of complacency when things are going well. But do note that the S&P 500 averages seven drops of 3% and three pullbacks of 5% every year since 1950. And the second half of February is normally weak in terms of seasonality as you can see below.

I don’t know what will ultimately happen with the S&P over the near-term, but I do believe it’s important for the average stock to catch-up to the major indexes if this bull market does have longevity.

So despite the small pullback and signs of extended momentum in the S&P over the past week, the recent action in small-caps is quite encouraging.

Last week, I wrote about growing signs among technical momentum indicators that small-cap performance was picking up. I also noted how a clear uptrend in small-cap growth stocks has marked several strong trading environments over the past decade.

That’s why last week’s action in the IWO small-cap growth exchange-traded fund (ETF) was notable. While large-caps look exhausted after breaking out to new all-time highs, IWO is attempting to clear a key hurdle in the weekly chart below.

The weekly chart of IWO shows the price taking out the $257 level, which is important resistance on the candlesticks in the chart. At the same time, the weekly MACD is just turning higher from the zero line, indicating that upside momentum could be in the early stages.

Follow through above the $265 level will now be key. If a rotation into small-caps is getting underway, then that will create more trading opportunities under the hood even if the larger cap indexes appear to be weakening.

Ultimately, this rally in stocks also hinges on the ongoing recovery in corporate earnings. That’s why more signs of a pickup in the economy’s rate of change is encouraging.

Like what you’re seeing with BofA’s Global Wave indicator below. The metric is comprised on things like consumer confidence and earnings revisions, and is recently turning higher from the 50 baseline.

That echoes other indicators I’ve shared recently like purchasing manager indexes (PMI’s) and the improving rate of change in leading economic indicators off a low level. That also comes on the heels of the Atlanta Fed’s first quarter GDP estimate that’s running at 2.9%. If economic growth can maintain (or perhaps quicken) that pace, then that bodes well for the earnings outlook.

I would also look for confirmation from small-cap stocks that receive over 90% of revenues from the domestic economy, which is another reason why the developing breakout from the range noted above offers a big clue about the outlook.

Ultimately, once the Fed starts cutting interest rates, the path of stocks comes down to whether or not the economy avoids recession as you can see below. At this point, I still maintain that the message coming from the stock market is a positive one for the outlook.

For example, the recent price action and setup in steel stocks is worth noting. The SLX steel ETF recently broke out to new all time highs from an ascending triangle where resistance was near the $70 level. Price is now back testing that resistance level as support and turning higher.

I’m also watching the breakout setup developing in Steel Dynamics (STLD). The stock is making a series of higher lows inside a pattern since May last year, and cleared resistance at $110 this past December. The stock is now testing the next level near $130, which can set up a breakout to new all time highs.

That’s all for this week. One of the stock market’s most extended leaders reports earnings this week with Nvidia (NVDA). The company’s chips are fueling the artificial intelligence (AI) hardware buildout, and investors will be fixated on the stock price reaction post earnings. But it’s the ongoing action in small-cap stocks that I believe will be most important to the overall outlook for the economy and stock market.

I hope you’ve enjoyed The Market Mosaic, and please share this report with your family, friends, coworkers…or anyone that would benefit from an objective look at the stock market.

For updated charts, market analysis, and other trade ideas, you can visit me here: www.mosaicassetco.com

Disclaimer: these are not recommendations and just my thoughts and opinions…do your own due diligence! I may hold a position in the securities mentioned in this report.