Are small caps sending off a big warning?
If history is any guide, the Russell 2000 is giving off some bad vibes.
By Anthony Mirhaydari
If you just pay attention to the Dow Jones Industrial Average ($INDU), things look peachy.
The index remains mired in a six-month-long sideways channel but continues to flirt with near new all-time highs.
The bulls have all the justifications figured out. The weather is the blame for the recent economic slowdown, in which Q1 GDP growth is on track to be revised to a -0.6 percent annualized growth rate, according to Macroeconomic Advisors.
Russian President Vladimir Putin is making diplomatic sounding noises again on Ukraine. The first-quarter earnings season has been salvaged after a rough start.
And Federal Reserve chairman Janet Yellen is coming up with new and exciting excuses to keep short-term interest rates near 0 percent -- where they've been perched going on six years now.
But a quick glance over at the small caps in the Russell 2000 -- which Janet Yellen in her testimony to the House of Representatives on Wednesday admitted were possibly trading at overvalued levels -- suggests trouble.
On Tuesday, the Russell 2000 closed below its 200-day moving average for the first time since 2012, ending an 18-month uptrend. This was a breakdown long in the making: There were no less than seven attempts during the past two weeks. The bulls simply couldn't resist the selling pressure any longer.
The dichotomy is stark. And if history is any guide, it's downright scary.
In fact, the gap that has opened up between small caps and large stocks was last seen near the very top of the past two bear markets.
According to Jason Goepfert of SentimenTrader, Tuesday was only the third time in 35 years of market history that the NYSE Composite was sitting at a 52-week high one day before the Russell 2000 dropped below both its 50- and 200-day MAs the next day.
The last two occurrences were March 12, 1999 and Nov. 1, 2007.
That's not all.
Through Wednesday, the performance differential year-to-date is quite large: The S&P 500 is up 1.6 percent while the Russell 2000 is down -4.6 percent. As a result, as highlighted by Bespoke Investment Group, the performance advantage that small caps enjoyed in 2013 has now been erased.
From the intraday high on March 4 into Wednesday's intraday low, the Russell 2000 dropped 9.8 percent. Since the bull market started in 2008, there have been two other drops of this magnitude. But here's the kicker: They selloffs didn't end until small caps suffered declines of more than 20 percent (in July 2010 and October 2011).
So far, the large caps have been resisting the selling pressure. During the 2010 selloff, small caps and large caps maintained a correlation coefficient (a statistical metric that measures how closely two sets of data follow each other up and down) of .985. That means the two were 98.5 percent aligned. In 2011, it was .992.
But right now, it's just .299, or 29.9 percent.
The $5 trillion-dollar question is: Will large caps fall to realign with small caps, or will the two go on their separate ways?
Moreover, small stocks aren't the only area warning of trouble. Despite declarations that the economy is surging again after a harsh winter, U.S. Treasury bonds have been well-bid -- traditionally, a sign that the bond market is pricing in trouble. As a result, 10-year yields have dropped back to the 2.6 percent level, down from a high of 3.05 percent at the end of 2013.
According to Citigroup research, the market stopped following the fundamentals in late 2012. That's when bond market spreads disconnected from the amount of borrowing companies were doing. And it's when stocks stopped responding to earnings revisions.
If bond investors no longer care about the creditworthiness of the companies they are giving their money to, and stock investors no longer care about the earning of the companies they are investing in ... how is that anything other than a bubble?
I've been recommending investors play it cautiously with a focus on Treasury bonds via ETFs such as the leveraged Direxion 3x Treasury Bond Bull (TMF), which is up nearly 12 percent since I added it to my Edge Letter Sample Portfolio in late February.
Put option positions recommended to clients in these names are up 240 percent and 411 percent, respectively.
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Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm. As of this writing, he has recommended TMF and puts against LULU and COH to his clients.
All I did is read the headline - How did I know it was you Anthony ?
“Like an oversexed guy in a harem,” he shot back. “This is the time to start investing.”
The Dow was below 600 when he said that. Before we could get Buffett’s words in print, it was up almost 15% in one of the fastest rallies ever.
We called him back and asked if he found the market as sexy at 660 as he did at 580. “I don’t know what the averages are going to do next,” he replied, “but there are still plenty of bargains around.” He remarked that the situation reminded him of the early ’50s."
another interesting situ is how closely the small cap chart (look at ticker "IWM") has been tracking the NASDAQ index (hit the chart "compare" button and then select nasdaq). now that the smalls have broken off going even lower than the nas, that is a potential problem for the overall market structure going forward - today (friday) is a good example as the smalls are leading the S&P and europe (EFA) downwards ...
the traders are playing games - watch what happens to the markets across the board at 1:30 EST (1330 for you mil or international folks)
good article anthony .. all true about yellen's newest speaking gaffe (the infamous "six months" was the last one) - even though it is true she shouldn't be opining on areas of the market or individual stocks or sectors - congress gets enough insider-trading info already.
small caps can certainly be an early indicator for broad market direction in normal times - but as you pointed out these are not normal times: there is a single manic focus of investors on .... te-dump-te dump-te-da ... "Dividends" ... yield is all that apparently matters here in Bubbleville, USA.
one thing we know from experience (and tulip bulbs) is that the force of gravity will eventually prevail ...
Posting on this guy's articles are a pain....
From a close I have in March on A Friday, the RUT is down about 8%
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