What Does Small Cap Outperformance Tell Us About SPX?

For good reason, investors are looking at the performance of the Russell 2000 (RUT). In 3Q13, RUT outperformed SPX by a wide margin, up 9% vs 4% for the latter. It performed even better than the Dow, which was up just 1% (chart).

Some background: RUT comprises 2000 companies with an average market capitalization of $850m. For SPX, the average company is over $30bn.

These are small companies, much less followed by Wall Street analysts, in turn making them more speculative. The average beta of RUT is about 30% higher than SPX. This is key. When equities are in favor, you should expect RUT to outperform SPX. The reverse is also true when equities fall out of favor.

So is RUT outperformance meaningful to SPX? Not really.

The chart below compares SPX (top panel) to the relative performance of RUT to SPX (bottom panel). When RUT outperforms, the line in the bottom panel rises.

And what we see over the last 10 years is that sometimes SPX rises to new highs when led by RUT (green arrows) and sometimes it does so when RUT lags (red arrows). The relationship is not clean enough to be helpful in understanding SPX better.

What is, in fact, worrisome is that RUT outperformance has often been a precursor to SPX topping out (again, the green arrows). That is essentially the situation today where the level of outperformance is equal to that in mid-2011 before a 20% correction.

So, what's going on? Two points.

Weekly Market Summary

Overall, indices and sectors are trending higher. A majority of cyclicals that broke higher two weeks ago (green shading) have held those gains over the past week (chart). Likewise with most indices, including those outside the US (chart). The notable laggards are the Dow and SPX.

The story so far is this: 2013 started like a rocket, with SPX jumping ahead by 18% by mid May. This is twice its typical annual return. The conventional wisdom in May was SPX would quickly go to 1800 in 2013.  It was in the bag.

Instead, in the 4 months since then, SPX has returned a net of zero. Moreover, risk/reward has been 3:1 negative during that period of time (i.e., upside relative to drawdown).

Despite this, core sentiment remains firmly in the 1800 and higher camp. To take advantage, fund managers have increased their equity exposure by more than a 1/3 since May (post).

So have individuals: according to Lipper, flows into equity funds and ETFs was the highest in more than 10 years last week (chart).

Since downside risk is considered minimal, margin debt also increased to a new high (chart).

And, not wanting to be left behind, former bears on Wall Street have capitulated (here).

There are few better examples of investor's confidence in the upside of equities than recent put/call ratios, which have been falling even as indices dropped over the past 7 sessions (chart). That's fairly remarkable behavior.

The big picture of a market losing momentum continues to be valid (post and chart below). Breadth confirms (chart). With investor expectations ahead of market performance, there is a potential for disappointment.

Weekly Market Summary

The surprise non-taper by the FOMC on Wednesday pushed all the indices and a majority of sectors to new highs. This created a large number of extremes that we noted at the close was likely to cause near term weakness (post). Indeed, by Friday, the Dow had given up all of its FOMC gains.

But, overall, most of the sectors, US indices and ex-US indices are holding their break outs and remain above rising 20 and 50-day moving averages (chart and chart). In particular, EEM continues to outperform domestic equities over the past 3 months, a good sign (post and chart).

Treasuries, which have been trading in tandem with equities recently, diverged higher. For the week, they handily outperformed equities and since August 2, performance between treasuries and SPX is near even (chart).  Out of favor bonds (chart and chart) look like they might have put in a bottom for now (post and chart).

Looking ahead, our biggest concern is an apparent loss in momentum.

Breadth is indicating a loss of momentum. Although indices have formed higher highs between May, August and September, cumulative breadth and the percentage of companies over their 50-dma has formed lower lows (chart).

This divergence in breadth indicates waning momentum as fewer stocks participate in the market's upside. That pattern of momentum loss is easily seen in the weekly Dow (here) and SPX (below) charts (note both RSI and MACD). As a guide as to what has happened previously under similar circumstances, this pattern in the Dow (here) continues to track.

Weakening momentum will be encouraged by two other factors.

Post-FOMC, Expect Some Reversion

On twitter, we have discussed the breakout in both sectors and indices. That is the trend, and betting against the trend is frequently short-odds.

But there were several extremes that became present an hour after the FOMC announcement. The combination of these extremes (as opposed to each one individually) suggest at least some near term consolidation if not reversion.

SPX hit its upper trend line from the May and August tops (red dashed line).

NYMO was 87 at the close. This is an extreme. Prior examples over 80 shown with a green arrow.

Fund Managers' Current Asset Allocation - September

Every month, we review the latest BAML survey of global fund managers. Among the various ways of measuring investor sentiment, this is one of the better ones as the results reflect how managers are positioned in various asset classes. These managers oversee a combined $700b in assets.

Overall, fund managers are extremely bullish on risk: exposure to global equities (60% overweight) is at the second highest since the survey began in 2001. At the same time, exposure to fixed income (68% underweight) is at the second lowest ever.

The upshot is this: in the past 4 months, both All World Ex-US Index and the SPX are net flat, but fund managers have increased their equity overweight by 17 percentage points. Since 2007, equities have not moved appreciably higher without moving lower first when funds are extremely overweight equities (dashed line is the current weighting).

Weekly Market Summary

On Monday, the intermediate trend turned back up. The 13-ema regained a positive slope and SPX closed above its 50-dma after being below the prior 3 weeks. A majority of sectors and indices are similarly above their key moving averages, led, importantly, by cyclicals (chart).

As mentioned in the past several weeks, what is particularly encouraging is the positive trend is being echoed in ex-US markets. The Euro 350 made new uptrend highs, the All World Ex-US index is close to doing so and EEM is outperforming SPX (chart). In 2013, the US has led, often alone; now, other markets are pushing higher as well.

Add to this both low volatility and macro beating expectations by the most in almost two years (chart), and investors have a feel-good story.

And there is no doubt investors feel good. All three put/call ratios hit extreme bullish readings on Monday and Tuesday, a rarity (chart). As Chris Prybal points out, put/call is now back at the same May/August level where SPX has subsequently fallen (chart). Similarly, AAII bullish sentiment is back near prior highs where, absent a recent long sell off, SPX has made little net progress (chart). The bull market is even on the cover of this week's Time magazine.

The market appears to be, in short, stuck in the late-stage rally dilemma: investors are very bullish, so each correction is short and shallow. And the lack of a more meaningful correction, one that shakes out longs and brings in fresh capital to fuel the next leg higher, leads to declining momentum.

The waning momentum is most evident on longer time frames. On the SPX weekly, the RSI (5) is making lower highs and lower lows without ever getting 'oversold' where the market resets and begins a successful leg higher (noted by green arrows). The shallow corrections (red arrows) have eventually failed each time.

In fact, 2013 is so far the first year since 1995 where the weekly RSI (5) has not become 'oversold' even once. Aside from that being 18 years ago, what is equally unusual is that in all the prior cases, the previous year has been a 'washout', either falling hard (like 1987) or trending sideways (chart). That type of action resets markets and establishes the base for the next sustained move higher. In comparison, the strength this year follows on the 13% gain made in 2012.

Waning momentum is also seen on the daily SPX chart. There have been 4 prior times since December where SPX has run higher at least 7 days in a row (like this week). In the following days/weeks, SPX has made minimal net progress (chart). Each of the prior times was a stair-step higher; this time, the rally overlaps with the one in July. In other words, a lot of energy was expended getting back to where SPX was two months ago. That is the very definition of waning momentum.

Finally, the loss of momentum is seen in breadth. Carl Futia shows that with indices challenging and/or exceeding prior highs, both cumulative advance/decline (chart) and net new highs (chart) are lagging. This implies that the rally is narrowing. Note that these divergences can persist for a time.

Nevertheless, the trend, as noted, is bullish, and with 2013 being such a strong year, underestimating this market has been an error.

But be aware that this rally to be getting tired. Two weeks ago we suggested that 2011 and 2013 are beginning to look very similar (post). If this is the case, then large cap stocks will form a slightly lower high in the weeks ahead with yet another lower weekly RSI (red arrow). The 2011 red arrow came during that summer's debt ceiling debate; ironically, we are now heading into another debt ceiling debate ahead of the October 15 deadline.

Weekly Market Summary

After falling 4 weeks in a row, DJIA and the other indices bounced. Recall that DJIA had been down a 5th week in a row only once (2Q11) in the past 6 years. So, a bounce was due, but it was fairly weak: none of the indices exceeded the prior week's high, instead forming inside candles.

The bright spot in the global equity landscape is ex-US. Earlier this year, Europe began trending higher and creating new highs. As a group, ex-US markets are finally trading above rising 50-dma (chart).

The laggard emerging markets are now outperforming the US over the past 10 weeks (chart). The set up for EEM outperformance was discussed here;  to this we can add that their valuation relative to book value is highly compelling (chart). Two sympathy plays, the Aussie dollar (chart) and steel (chart), are confirming.

In the US, treasuries, which had outperformed equities by 500bp in August, gave up all those gains this week. Over the past 5 weeks, they are now back to equal performance (chart). Of note, investor positioning on treasuries could not be more lopsided (chart).

The above, on balance, is of course positive for equities on a longer timeframe. Over the next few weeks the key question is whether last week's rise was a B (up) wave in an ABC correction that lasts through September, or the start of a YE rally?

For the broader market, we have previously spelled out what to look for at a washout low (post). Many of these conditions have not yet triggered. Despite weakness in US equities over the past month, allocations to equities (chart and chart) and investors' outlook (chart and chart) have not changed by much. Breadth (chart) and the SPX 13-ema (chart) are also in a short-term bearish configuration. All of this suggests a final C (down) wave is likely to come, but the end of the correction is probably close.

September 2013: What Will Drive Equities Higher In The Next 12-Months?

This rally, which started in 2009, has now run 1640 days, which is well over double the average 'cyclical bull market' of the last 80 years (article). It is, in fact, the third longest cyclical bull market of the post-depression period. The percentage gain (140%) is also nearly twice the average and the third highest.

It is, in other words, the right time to ask what, if anything, will drive the indices higher before they instead head lower.

(Note: 'Cyclical' bull markets are distinct from 'secular' bull markets. A secular bull market (1982-2000) is generational and comprised of several cyclical bull and bear markets, each lasting two years on average (as above). Read further here or here. This post is only focused on the cyclical trend).

There have been two distinct stages to this bull market.

Stage One ran from 2009 to late 2011 and was driven primarily by fundamentals: strong sales growth and strong earnings growth (EPS doubled; sold blue line below). In Stage One, fundamentals outpaced the appreciation in the indices.

The second stage has run from late 2011 to the present. Fundamentals have slightly improved but Stage Two was overwhelming about the indices becoming revalued upwards. Since the end of 2011, less than 20% of the gains in the SPX can be accounted for by EPS growth; the remaining 80% has been multiple expansion. The chart below shows the rise in the trailing 12-month (TTM) PE; it has increased by one-third in Stage Two.

If fundamentals drove Stage One and valuation drove Stage Two, what will drive the next leg higher?