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).