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Is the Russell 2000 Outperformance Nearing an End?

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You're nobody 'til everybody loves you!

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Year-to-date, the Russell 2000 (RUT) is up 8.2%, compared to just 2% for the S&P 500 (SPX), 3.7% for the Nasdaq-100 (NDX). Scott Reamer sent me an interesting chart this morning showing the SPX/RUT ratio going back to 2000.
SPX/RUT Ratio
(Chart courtesy Bloomberg)

As the chart above shows, we do appear to be getting to an extreme in the outperformance of the Russell 2000 compared to the SPX.
Another way to lok at this chart is to plot the ratio on a percent scale PnF chart. The reason I like to look at them this way is because the reversals on the chart provide difinitive signals whereas the line charts require a more subjective judgment.
On the PnF chart, the ratio chart is either in Xs, indicating outperformance for the numerator, or Os, indicating outperformance by the denominator.
Looking at the SPX/RUT ratio chart on a PnF basis, we can easily see that this ratio is the lowest it has been since 1988 and 1994.
SPX/RUT PnF ratio 1988-present
(Chart courtesy Dorsey Wright)
The most recent column added an O (indicated by a 1 in the red zone highlighted) on January 24 this year. It is now at what looks like an extreme using the data going back to 1988.
What happens when the SPX/RUT reaches this level? One way to look at it is to use the PnF chart reversals to calculate performance. For example, because we are now at the lowest level reached on the chart since 1988 and 1994, we can look at what happened in those two periods based on the subsequent reversals.
Below is the first period highlighted on the chart in blue. The lowpoint occurred on July 12, 1988. The reversal to Xs, which indicated the SPX had outperformed the RUT enough to cause a reversal in the ratio, occurred on July 27, 1989. The reversal down, which indicated the RUT had outperformed the SPX enough to cause a reversal in the ratio took place on February 28, 1991.
SPX/RUT PnF ratio (blue region highlights July 12, 1988 - to Feb. 28, 1991)
(Chart courtesy Dorsey Wright)
From July 28, 1988 (the low point on the chart) to the reversal back to Os on Fe. 28, 1991, the SPX was up 37%, compared to just 6.2% for the RUT.
Note that it took more than a year for the SPX to outperform the RUT enough to cause the reversal once the lowpoint on the chart was reached. What if we waited for the reversal?
The reversal to Xs from the low point in the blue region above occurred on July 27, 1989. From the reversal up to the reversal down, Feb. 28, 1991, the SPX was up 7.3%, compared to a decline of 8.2% for the RUT. These figures are exclusive of dividends.
Let's move on to the second period the ratio reached this extreme.
SPX/RUT PnF ratio (blue region highlights Feb. 10, 1994 - to Sep. 30, 1997)
(Chart courtesy Dorsey Wright)
From Feb. 10, 1994 (the low point on the chart) to the reversal back to Os on Sep. 30, 1997, the SPX was up 102%, compared to "just" 71% for the RUT.
This time it again took the SPX more than a year for the reversal to Xs to take place on the PnF chart. The reversal to Xs in the blue region on the chart above took place on May 4, 1995. From that reversal to the reversal back to Os on Sep. 30, 1997, the SPX was up 82%, compared to 71% for the RUT. These figures are, again, exclusive of dividends.
This is very limited data, obviously, but what it suggests is simply that the outperformance gap between the RUT and the SPX may very well be at an extreme. I used a percent scale of 3.25%. Obviously, by tweaking that percentage, one could with a small degree of effort arrive at a more fine-tuned approach to looking at the Russell 2000 vs. the S&P 500.
But wait a minute, c'mon, man, you don't want to own ExxonMobil (XOM), General Electric (GE), Pfizer (PFE), Wal-Mart (WMT) and Microsoft's (MSFTS) of the world, do you? Because with the cap-weighted SPX that is exactly what you are getting. Aren't those stocks immovable objects? Over-owned, burned out stars? How will they increase revenues? Clearly, I am doomed.
Yes, there is really no good fundamental reason to own the no-growth, burned-out stars that make up the heaviest weighting in the S&P 500 against selling the Russell 2000. So why do I find the idea so interesting? Because there really is no good fundamental reason to own the no-growth, burned out stars that make up the heaviest weighting in the S&P 500 against selling the Russell 2000.
I have found the best trades are frequently the trades nobody likes.
No positions in stocks mentioned.

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