The Bear Who Cried Wolf
“Dow closes at a record high, again”
“Alibaba IPO Skyrockets After Initial Offering”
“S&P at new high as dovish Fed maintains rates to stay low for a ‘considerable time'”
These were the prominent headlines of two Fridays ago. They were all unmistakably positive, but lurking underneath the surface was a nagging divergence that I’ve been commenting on all year (see most recently, Perception vs. Reality). If it feels like the movie Groundhog Day, it should. For the third time in 2014, small cap stocks are moving in a wildly different direction than the large cap indices.
We first started observing this sharp divergence back in a March, when the Russell 2000 commenced a decline that took it down over 10% by mid-May. This weakness led to an only minor 4% pullback in the S&P 500 that was quickly followed with new all-time highs.
Next, in July, the weakness resurfaced once more, with the Russell 2000 declining nearly 9% by early August. Again, this lead to an only a minor 4% pullback in the S&P 500 that was quickly followed with new all-time highs.
Most recently, in early September, we again saw weakness in small caps emerge once. Large caps initially shrugged off this weakness with a last gasp push to new highs on the euphoria leading up to the Alibaba IPO. We’ve since seen a minor pullback but emboldened by the benign outcomes earlier in the year, many seem to be arguing a repeat performance will occur and that yet another v-shaped rally will ensue.
While anything is possible, this is not the most probable outcome in my view and we are likely closer to a breaking point in this historic divergence. The Russell 2000 finished down over 7% last quarter while the S&P 500 managed to eke out a small gain. While the two indices don’t need to trade in lockstep, it is unreasonable to think that large caps will continue hitting all-time highs when the average stock is nearing new 52-week lows.
Another factor suggesting the re-synch may be with large caps catching up to the downside is sentiment. Back in June I argued that the wall of worry that persisted for much of the bull market was no more and that the consensus now believed volatility was dead and would stay low for years to come. More recently, we have witnessed a lampooning of anyone who still dares to question the sustainability of this rally (think of Marc Faber, Rick Santelli, and Bill Fleckenstein to name a few). This increased ridiculing has led to a dearth of Bears not seen since 1987.
Those striking a cautionary tone here are being treated like pariahs, even though the average stock is down for the year through the first nine months (see chart below). The contrarian in me is starting to think that now that everyone is dismissing this broad weakness, it will finally start to matter.
For the better part of the year, I have been arguing that it is already starting to matter, just not in the black or white way most view the market. With the prospect of QE3 ending in October, real money investors have been rotating out of riskier areas of the market and into more defensive areas for the entire year.
Thus far in 2014 we have had an environment that has paid investors to play defense, not offense. This is surprising to most as all-time highs are all we have been hearing about for much of the year. But if we look at the most defensive areas of the market, including Utilities and long duration bonds, there is no denying it: crying about the diverging small-cap wolf was actually justified.
And because no one believes this wolf will matter this time around as it has failed to lead to a large cap correction in the recent past, it more likely than ever to catch many by surprise.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of two award-winning research papers in 2014 on Intermarket Analysis and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
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