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).