Tuesday, September 23, 2014

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).

So, if you view the current market as remaining in bull mode over the next year, buying RUT now likely will pay off. But this analysis tells us very little about RUT itself. Investors' capital is finite: a dollar invested in one asset is an investment foregone in another asset.

The better question for investors is this: are investors better off buying RUT or SPX after a death cross?

As it turns out, they are better off buying SPX. In the chart above, RUT was a buy 9 times following a death cross. In the chart below, SPX outperformed RUT in 5 of those 9 times (top panel).

Moreover, in 2 of the 3 times the death cross led to lower prices, SPX also outperformed RUT.

The death cross in RUT by itself is an indicator with relatively little meaning. RUT doesn't consistently lead the market lower at tops; if the broader market is moving higher, so will RUT.

It's better to watch SPX than RUT. A turn lower in the moving averages for SPX holds far more significance than it does for RUT, for a simple reason: that's where the money is.

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