RUT Has Reached An Important Juncture

It's an overused phrase, but this is an important juncture in the market.

Weakness in the small cap index, RUT, has reached the point where just 23% of the index's components are above their 50-dma. In the past 2 years, this has been the buy point for every rally; the only time this measure of breadth has been lower was November 14-15, 2012, right before a 60% rally. Before that, it was lower on June 1, 2012, right before a 20% rally (chart from Sentimentrader).

The Set Up For A 4th Quarter Rally Is Missing Something

The end of the year is known for being seasonally strong. Even October, renowned as the month for exceptional drops, has recently been one of the best months of the year. Over the past 20 years, the October - December stretch has been the strongest period of the year (chart from Bespoke).

That is especially true during mid-term election years. These years usually meander until the 4th quarter, and then rally. Crucially, that continues into the third presidential year when stock returns are the greatest (chart from BAML).

Weekly Market Summary

After making bull market highs last week, equities lost 1% this week, led by small caps (RUT) which shed another 2.4%. With RUT now down 8% from its July high and under its 200-dma, investors are starting to wonder whether a larger correction is underway.

One reason to expect a larger sell off is that that has been a pattern during mid term election years. As an example, in the past four mid-term years, SPX has sold off by 8%, 16%, 20% and 34%; from its high to its eventual low has taken 2-6 months.  In the past 6 months, the largest correction was 4.5% and took just 11 days.

Quartz: The 22 Best Twitter Feeds You Should Follow

Many thanks to the people at Quartz for including us in their list of the 22 Best Twitter Feeds You Should Follow. The full list is here and includes heavy weights from BIS, the WSJ, Pew, The Economist, Reuters, Bloomberg, RBS, Credit Suisse, Dealogic, Business Insider and others. We're honored.

Buy SPX on the Death Cross in RUT

We discussed weakness in RUT over the weekend. Our conclusion was that relative strength or weakness in RUT in the past has been an inconsistent indicator for the broader market (post).

This is consistent with a prior post where we analyzed significant market corrections and found no reliable relationship between market tops and the relative performance of RUT and NDX (risk indices) versus the SPX and DJIA (large cap indices; post).

The chatter in the market now is that RUT is experiencing a "death cross", where its 50-dma is crossing below its 200-dma. The conventional wisdom is that this indicates weakness in trend and is therefore bearish. The contrarian point of view is that many "death crosses" coincide with good buying opportunities. So, which is it?

The evidence for the contrarians looks more compelling on first glance. The vertical lines are each death cross (lower panel) in the past 20 years. More often than not, RUT (top panel) moved higher in the months after a death cross.

If you look more closely, you will notice that RUT only moved lower after death crosses in 2000-02 and 2007. These were bear markets. In other words, buying the death cross in RUT worked because the broader market was in a bull market (1995-1999; 2004-06; 2010 and on).

Weekly Market Summary

SPX, DJIA and NDX all ended the week at new highs. For them, the trend remains higher.

What is most interesting is the small cap index, RUT. Not only did it lose 1.2% this week while the other indices gained, but it is now more than 5% off its peak. For the year, RUT is negative and SPX is up 9%.

Is this divergence between SPX and RUT bearish? It would seem it should be. When small caps underperform, it indicates weakness in breadth as investors concentrate their buying in a relatively small number of large companies.

The problem is these divergences have usually not been bearish in the past few years. The yellow highlights below are times when small caps underperformed large caps (lower panel). Each time, SPX continued higher (top panel). The main exception was in 2012 (in orange).

Moreover, there were several instances where small caps outperformed large caps right into a market peak (shown with arrows). If anything, that has been a better predictor of trouble for SPX. Why would this be? When small caps outperform, investors are chasing performance. It's a beta chase, and this indicates exuberance. At an extreme, this exuberance is punished with a market correction.

Why Late 90s Euphoria Is Not Coming Back

A recurring meme in the stock market is that retail investors today are not as enamored with equities as they were in the late 1990s. The softly spoken corollary is that until we see that level of euphoria, stocks will continue to rise unabated.

If you missed the 1990s, here are two personal anecdotes to describe what it was like:

1. Online trading services like E-Trade were brand new. Our firm was hired to advise one such company in 1998. During the course of several focus groups, former policemen and teachers described how they had left their jobs to day trade. But it wasn't just their own capital; they were also trading the savings and retirement accounts of their neighbors and family members.

2. In late 1999, we sat down with the CEO of mid-sized technology firm in Silicon Valley. As the meeting started, the CEO bought stock. Two hours later, he sold for more than a million dollar gain. The next week he used that money to pay 30% over the ask for a $4 million property in Atherton. He razed the nearly new house on the lot three months later.

Imagine this: the Nasdaq nearly tripled between 1996 and 1998. Then, in the next 18 months, it quadrupled. How do you think that impacted investor psychology?

That was the investment climate attracting former policemen and teachers to day trading. In comparison, the market's 60% rise since the start of 2013 seems rather drab.

There was a legendary IPO frenzy in the late 90s. Theglobe.com went public in November 1998 at a price of $9. On the first day, it traded up to $97. Side note: by 2000, it was trading at 10 cents.

VA Linux gained 700% on its first day of trading in December 1999. The company was valued at $9 billion. The year before, Linux had $5 million in sales and earned a total of $84,000 in profits.

Why The Economic Recovery Has Been So Slow

Many market watchers continue to express surprise over the modest pace of recovery in the US economy since 2009. Are they right to expect growth to have been more robust?

The short answer is no.

The 2008 recession is not comparable to other downturns since the end of World War II. Therefore, expecting the recovery to track the pace of prior recoveries is misguided.

With few exceptions, post-war recessions have primarily been led by inflation and monetary tightening. Some of these came as a result of war: the Korean War in the 1950s and the Vietnam War in the 1960s, when government spending contributed to price hikes. In the 1970s and early 1980s, the primary cause for inflation were sharp spikes in the price of oil. To a lesser degree, that was also the case in 1990.

While 2000-02 is remembered now for the substantial fall in equity prices, the economic downturn was actually mild. The dot-com bubble had burst and then 9/11 took place. But GDP contracted by just 0.3% and unemployment peaked at just 6.3%. It was a stock market recession more than an economic recession.

The economic contraction in 2008 was nothing like any of these recessions. Inflation and monetary tightening had nothing to do with the recession: core CPI peaked at just 2.5%.

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 allocated in various asset classes. These managers oversee a combined $700b in assets.

First, here is a quick recap of the story over the past few months:

Fund manager equity allocations reached an extreme in July. At +61% overweight, it was the second highest since the survey began in 2001. This was a clearly identified risk to near term equity performance (post).

In early August, the Euro 350 dropped 8% and SPX dropped 5%. In response, equity allocations fell to +44% overweight.

Moreover, fund managers moved to cash, with cash levels shooting up to 5.1%, also an extreme. As we specifically noted a month ago (post), this was a strong positive: cash above 5% has been close to equity lows in 2002, 2003, 2011 and 2012 (green shading).

Which brings us to the current survey of fund managers' positions. SPX and the Euro 350 rose more than 5% in the past month. Fund managers have responded by raising their global equity exposure to +47% overweight and reducing their cash to 4.6%.

Business Insider: Top Finance People to Follow

Many thanks to the people at Business Insider for including us in their annual list of the Top Finance People to Follow for a second year. The full list is here.

Weekly Market Summary

Today's widely anticipated employment report (NFP) reaffirmed that growth remains positive but tepid. 142,000 jobs were added in August, well off the expected print of 220,000 new jobs.

Was this "miss" really a surprise? No.

This month's print follows those of 84,000 in December and 288,000 in June. Moving between extremes like these is nothing new: it has been a pattern during every bull market. Since 2004, every NFP print near or over 300,000 has been followed by one near or under 100,000 (circles).

We should also note that a "miss" of 80,000 jobs is equal to 0.05% of the US workforce. Assuming greater forecasting precision is folly.

The largely ignored bigger picture is more instructive. In the past 12 months, NFP has averaged 207,000. That is close to the middle of the range in the chart above.

September Macro Update: Trend Growth of 2% Real

In May we started a recurring monthly review of all the main economic data (prior posts are here).

Our key message has so far been that (a) growth is positive but modest, in the range of ~4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely. This is germane to equity markets in that macro growth drives corporate revenue and profit expansion and valuation levels.

This post updates the story with the latest data from the past month.

The overall message remains largely the same. Employment is growing at less than 2%, inflation and wages are growing around 2% and most measures of demand are growing at roughly 2% (real). None of these has seen a meaningful and sustained acceleration in the past 2 years. The economy is continuing to repair, slowly, after a major-financial crisis. This was the expected pattern.

We'll focus on four categories: labor market, inflation, end-demand and housing.


Employment and Wages
The August non-farm payroll (142,000 new employees) was at the lower end of a 10-year range. (The past 12-month average of 207,000 was, on the other hand, right in the middle of the range). This follows prints of 84,000 in December and 288,000 in June. Moving between extremes like these is nothing new: it has been a pattern during every bull market. Since 2004, every NFP print near or over 300,000 has been followed by one near or under 100,000 (circles).