Editor's Note: This article was originally published in John Murphy's Market Message on Friday, October 25th at 5:04pm ET.

---

A lot of positive groups rotations have taken place in the stock market over the past two months. We've seen new money moving into domestic small caps stocks, as well as economically-sensitive transports. We've also seen cheaper value stocks gaining ground on growth stocks. The most notable rotation has been into financial stocks which have gone from market laggards to leaders over the last two months. There may be one common thread tying all of those rotations together. And that is a steeper yield curve caused mainly by rising Treasury bond yields.

The daily bars in the lower part of Chart 1 show the Financial Sector SPDR (XLF) rising above its July/September peaks to reach the highest level since early 2018. That represents a bullish breakout. The change in relative performance is shown by the XLF/SPX ratio in the middle box. That ratio bottomed during August and is now challenging its early June peak. An upside breakout appears to be taking place there as well. Financial stocks are influenced by the direction of bond yields and the yield curve. Rising bond yields are beneficial, especially when accompanied by a steeper yield curve. And that's just what we're seeing in the upper box in Chart 1.

The green area plots the spread (or yield curve) between the 10- and 2-year Treasury yields. Falling bond yields from June to August flattened the yield curve and caused financial stocks to weaken. The red area during August showed the 10-year yield falling below the 2-year which caused that yield curve to briefly invert and raised fears of an economic slowdown. The upper box, however, shows that version of the yield curve bottoming in late August and rallying sharply since then. That was caused mainly by a rising 10-year yield. Notice the close correlation between the rising green area and the XLF/SPX relative strength ratio just below. And both coinciding with a major upturn in financial stocks. The steeper yield curve over the last two months may account for a more optimistic view on the U.S. economy and the stock market. And may also explain the recent strong performance by small caps and transportation stocks as well as other groups tied more closely to the U.S. economy.

Chart 1

On each of the past two Mondays, I've hosted webinars that have highlighted stocks poised to trend higher with earnings results. It's a concept I discuss frequently and most of it has to do with relative strength. If Wall Street is accumulating, we need to take notice. It's as simple as that. My crystal ball approach to earnings season hasn't been perfect, but it's certainly been a whole lot better than a coin toss.

During each of the past two webinars, I've highlighted some 70 or so stocks, giving them either a green arrow or a red arrow. The green arrow suggested to me that the stock was performing well on an absolute basis as well as a relative basis. Based on that, I indicated these would be stocks to consider holding into earnings. The red arrow suggested the opposite, that absolute and relative weakness would have me concerned heading into earnings reports. A few stocks had black arrows, which simply meant I wasn't sold either way. While holding any one stock presents considerable risk, I believe these webinars proved my theory that relative strength really does matter heading into earnings reports.

Let's talk numbers and results.

Of the 47 stocks that I covered and assigned green arrows:

• 15 gapped up by at least 3% after earnings, while just 4 gapped down by at least 3%
• Only 2 gapped more than 10%, both to the upside - TSLA and RMD
• From the close prior to earnings to the Friday, October 25th close, these stocks gained an average of 2.82%, nearly triple the average of the gains for red arrow stocks
• Stocks gaining more than 3% from the close before earnings to Friday's close: 21*
• Stocks gaining between +3% and -3% from the close before earnings to Friday's close: 21
• Stocks losing more than 3% from the close before earnings to Friday's close: 5*

Of the 20 stocks that I covered and assigned red arrows:

• 6 gapped up by at least 3% after earnings, while 4 gapped down by at least 3%
• None gapped up or down by more than 10%
• From the close prior to earnings to the Friday, October 25th close, these stocks gained an average of 1.03%
• Stocks gaining more than 3% from the close before earnings to Friday's close: 6*
• Stocks gaining between +3% and -3% from the close before earnings to Friday's close: 10
• Stocks losing more than 3% from the close before earnings to Friday's close: 4*

All of these statistics were interesting, but the bold numbers with asterisks were perhaps the most telling. The ratio of strong post-earnings performance to weak post-earnings performance suggests that we should absolutely be paying attention to how stocks perform PRIOR to their earnings in order to better estimate how they'll perform AFTER earnings.

Here are the charts of the two best reactions to earnings of those I had predicted:

TSLA:

Despite not making the critical price breakout above 265, TSLA was showing steady relative improvement over the past five months. The massive volume confirming the breakout is undeniable. TSLA will see profit-taking at some point and become an attractive trade in Q4.

RMD:

RMD was a bit more complex to review. Relative strength appeared to be declining over the past two months, but medical equipment stocks ($DJUSAM) in general were in decline. Check out the volume; if Wall Street was truly distributing shares of RMD, the volume would have been much more significant on the selling. That never happened.

While there were a few "whiffs" by relatively strong stocks, I believe the biggest may have been by Baxter Int'l (BAX). I had marked this one with a green arrow, but obviously Wall Street was not impressed by their latest results and guidance:

BAX seemed to be performing just fine, especially against its medical supplies peers ($DJUSMS). But the company missed its revenue estimate and, worse yet, indicated potential misstatements in prior quarters. As a former practicing CPA, I can tell you that I don't want any part of a company whose financial data integrity is compromised. Run for the exits! That's what Wall Street did on Thursday and Friday and I believe it'll be quite sometime before BAX regains the confidence of the Street.

I looked ahead to Monday's after-hours earnings reports and came up with 5 that I've given "green arrows" to. I'm sending those annotated charts out to EarningsBeats.com members on Sunday night. If you'd like to receive those, simply CLICK HERE to start your 30 day trial for just $7.

Happy trading!

Tom

The Russell 2000 Index bullishly broke back above its key simple moving averages over a week ago and, as you can see in the chart below, this Index has been able to remain above this key area of support. And while it’s not the first time this year that these smaller-cap stocks have tried to turn positive, Friday’s breakout of a tight-range flat base is certainly encouraging.

DAILY CHART OF RUSSELL 2000 SMALL CAP INDEX

Technology stocks had a breakout as well, after last week’s rally pushed this sector out of a 3-month base. This puts the Tech sector in a leadership role after hitting a new high in price. A careful review of the biggest movers within Tech shows that many Smaller Cap names had sharp advances and now have charts that point to more possible upside. Below are three interesting Tech names with solid growth prospects for your review.

DAILY CHART OF TECHTARGET (TTGT)

The first company is TechTarget, Inc. (TTGT), which provides marketing and sales services for enterprise technology companies in the IT sector, including storage, security and networking. While there’s been concern over demand for these products from larger corporations, TTGT’s mid-sized marketplace is continuing to see growth.

The company has surpassed earnings estimates for the past several quarters and is due to report Q3 earnings early next month. This week, TTGT broke back above its key 50-day moving average following a pullback that began with September’s drop in the markets. The move came as analysts are raising estimates for both this year and next, which is a bullish sign going into their early November report.

DAILY CHART OF GOGO INC. (GOGO)

The second stock is Gogo Inc. (GOGO) which provides inflight broadband and connectivity as well as wireless entertainment services to the aviation industry. The company is the global leader in its field and, in addition to upgrading their capabilities with aircraft satellites and a proposed 5G rollout, they’ve just expanded their reach into the Chinese market.

The stock posted terrific returns in September following a delayed response to strong earnings reported in August as well, as a positive response to partnership announcements that will increase usage of their subscription-based services on flights.

While the September pullback was a bit more than the broader market’s selloff, the stock is now forming the right side of a base, with buyers picking up discounted shares as analysts raise estimates.

 DAILY CHART OF EXPO INC. (EXPO)

Next up is a global provider of telecommunication’s testing systems based in Canada. EXFO Inc. (EXFO) offers what they call a “highly differentiated” offering for fiber, 5G mobility and virtualization. After completing a restructuring program, management feels they’re now ready to generate long-term growth.

I’m not a real fan of stocks that have a price below $5.00. However, after working closely with a hedge fund that’s boosted gains with a careful selection of these lower-priced stocks, I can see that tight stops - and an understanding that the price swings will be higher than average - can go a long way.

As you can see in the chart, the stock is poised to break out of a 4-month base at $4.30 and, should EFXO advance further, the next breakout level is $4.97. Currently, the stock is extended given its recent rally and can be bought on a pullback to its 10-day simple moving average.

While each of these highlighted stocks is attractive, it's important to note that Smaller Cap stocks tend to be more volatile than their Larger Cap counterparts which makes them a riskier asset class. That said, the returns can far outpace the broader markets as long as their uptrends remain in place and their prospects bright.

Over the next week, I'm very excited to announce that fellow StockCharts.com commentator Arthur Hill and I will be unveiling our new stock-picking service, where we'll announce 2 new highly-curated stock picks each week. If you'd like to get on the waiting list for more information, please use this link here.

Additionally, for those who'd like to trial my highly-regarded MEM Edge Report newsletter, which provides sector strategy insights as well as sentiment updates on individual stocks, please use this link here so you can access a 4-week trial at a nominal rate.

Warmly,

Mary Ellen McGonagle

MEM Investment Research

Selection of Consumer Discretionary stocks vs XLY

In last week's Sector Spotlight episode, I discussed the positive rotation of the Consumer Discretionary sector on RRG. During the live show, I focused (too much) on the sector and only managed to talk about a few individual stocks. This article will highlight some of the names in that sector that are worth keeping an eye on.

To find this selection of discretionary stocks that are displayed on the RRG above, you'll need to do the following:

1. Load the members of the Consumer Discretionary sector on a weekly RRG against XLY (available in the drop-down box).
2. Toggle through the stocks using Ctrl+Dn to highlight the tails and analyze the rotation.
3. Note the stocks showing a "strong" rotation. In general, that means an RRG-Heading between 0-90 degrees, inside improving and close to 100 on the RS-Ratio scale, inside leading and coming from either improving or from weakening or, lastly, inside weakening but at high RS-Ratio values and curling back up (rising on the RS-Momentum scale)
4. Repeat 1-3 on a daily RRG.
5. Compare notes for both and see if stocks show up on both time frames, good or bad.

The daily version of the selected stocks is printed below:

Selection of Consumer Discretionary stocks vs XLY

EBAY

EBAY is the stock to watch out for in this sector! On the weekly RRG, it just crossed over from weakening into lagging, while the tail on the daily RRG shows a sharp rotation back into lagging following a short move through improving.

The sharp drop in the last two days has brought EBAY to support at $35, from which a recovery rally can take place to close the gap at $38 or test former support as resistance at $37. From a relative point of view, the trend is now definitely broken.

Dropping below $35 on the price chart will very likely accelerate a further decline.

Tiffany & Co.

Of the stocks inside the improving quadrant, I like TIF most.

On the price chart, it is breaking a downward-sloping resistance line as well as taking out its previous high. Both are positive signs, and the break above its previous highs, after having put a higher low into place, triggered a new uptrend in price (higher lows followed by higher highs).

A similar situation can be seen in the relative strength line against XLY. The downward-sloping resistance line has been broken and the last peak is about to be taken out to the upside.

All in all, TIF seems ready for more upside movement.

NIKE

NKE is a bit tricky. On the weekly RRG, the tail has just entered the leading quadrant but has been flat for the last week. On the daily RRG, the tail is inside the weakening quadrant and heading towards lagging but is still well above the 100-mark on the RS-Ratio.

The sharp drop in price last week has taken NKE back to its breakout level near $90. As long as this level holds, that seems to be a good buying area (with stops just below that gap-area of $88-90).

The bounce off of overhead resistance in relative strength has caused the tail to flatten this week. For the rotation to continue positively into the leading quadrant, that barrier needs to be broken soon.

The daily chart shows more detail. The gap-support area between $88-90 is clearly visible here, and so is the overhead resistance in relative strength.

The JdK RS-Momentum line is now dragging the RS-Ratio line down towards 100. When support in price holds, the relative momentum will recover rapidly, pulling the tail back up into the leading quadrant on the daily RRG as well.

This scenario anticipates that support in price will hold up and allow the strong relative rotation on the weekly RRG to continue. With short stops and close monitoring, this is a good risk/reward situation.

-Julius

---

My regular blog is the RRG Charts blog. If you would like to receive a notification when a new article is published there, simply "Subscribe" with your email address.

Julius de Kempenaer

Senior Technical Analyst, StockCharts.com

Creator, Relative Rotation Graphs

Founder, RRG Research

---

Want to stay up to date with the latest market insights from Julius?

– Follow @RRGResearch on Twitter

– Like RRG Research on Facebook

– Follow RRG Research on LinkedIn

– Subscribe to the RRG Charts blog on StockCharts

---

Feedback, comments or questions are welcome at Juliusdk@stockcharts.com. I cannot promise to respond to each and every message, but I will certainly read them and, where reasonably possible, use the feedback and comments or answer questions.

To discuss RRG with me on S.C.A.N., tag me using the handle Julius_RRG.

RRG, Relative Rotation Graphs, JdK RS-Ratio, and JdK RS-Momentum are registered trademarks of RRG Research.