Thursday, May 8, 2014

Risk Indices Don't Consistently Lead, or Lag, Before Corrections

The conventional wisdom is that "risk indices" lead. As long as RUT and NDX are making new intermediate-term highs, the market is considered healthy.

We should, therefore, expect them to peak before the large cap indices, SPX and DJIA. If large caps decline but RUT and NDX continue to climb, "risk is on" and the divergence is expected to resolve higher.

Is the conventional wisdom correct? Do RUT and NDX tend to peak before SPX and DJIA?

The short answer is no. The slightly longer answer is that there is absolutely no correlation between market peaks and index leadership: sometimes large caps peak first, sometimes they peak last. Even more telling, sometimes SPX and RUT will peak together and DJIA and NDX follow.

The first chart looks at greater than 20% declines over the past 25 years. The numbers indicate which index peaked first, second, third or fourth.

DJIA peaked first in 2000, SPX peaked last and the risk indices were in-between.

In 2007, RUT peaked first, NDX was last and the large cap indices were in-between.

We're not splitting hairs with the timing of these peaks. There has been a 3 month lag between the first and last index peaking. The current divergence between RUT/NDX and SPX/DJIA has lasted 2 months so far, which is not unusually long.

The next three charts look at corrections greater than 10%. The message is the same, with risk sometimes peaking first, sometimes last and sometimes in the middle.

Sometimes all four indices are synchronized and peak together.

Sometimes RUT and NDX will correct more than 10% and the large indices do not. That is something to keep in mind now with RUT and NDX especially weak and SPX and DJIA near their highs.

None of this should be surprising. Markets correct or enter bear markets for a variety of reasons. Large caps have more foreign market exposure. They also have greater exposure to banks. The risk indices have wider swings in earnings growth and are more prone to becoming over valued. The dominant factor driving markets determines which peaks first or last, not whether they are risk indices or focused on large caps.