-- Benjamin Franklin
While broader stock market averages have, on the surface, not fallen much since recent volatility began, there was quite a bit of destruction in high-beta areas. Biotech and social media have gotten the most attention, but the bigger breakdown from a big-picture perspective has been in small caps. In general, the Russell 2000 (INDEXRUSSELL:RUT) has been the darling for bulls since early 2013, after a monster move in US stocks. Much of this was due to their characteristics as high growth, less liquid, more volatile ways of expressing an investment view. Academic studies show that small caps tend to outperform with a lag at turns from downtrend reversals. On the other hand, at tops, they tend to be the first to sell off.
The action here has been ugly. Despite hope for reflation and economic data improvement, domestic small-cap areas have underperformed fairly substantially. Since the early March high, small-cap averages are down around 9%. This impacts market breadth, since there are more small-cap companies than large-cap names. Such a sell-off can mean one of two things: the first is that smart money overshot on the upside last year, and that this is a return to fair valuation; the second is the very real possibility that investors are anticipating some kind of slowdown on the domestic front.
How can that be? After all, the Federal Reserve is pulling back on stimulus, and data on the margin appears to be improving. While we do not know what it is that's causing investors to worry, the fact that long-duration Treasuries have performed so well is a cause for concern, and that should make people question what's really happening beneath the surface. Take a look below at the price ratio of the Russell 2000 ETF (NYSEARCA:IWM) relative to the S&P 500 (NYSEARCA:SPY). As a reminder, a rising price ratio means the numerator/IWM is outperforming (up more/down less) the denominator/SPY. Note that nearly all the outperformance generated in 2013 has been taken back in just the last four weeks. This, combined with Treasury strength, suggests something else is happening.
Something is amiss. Utilities strength also remains a key issue, given that their strength tends to precede periods of higher volatility and corrections for markets going back to 1926. A 2014 Dow Award-winning paper I co-authored, "An Intermarket Approach to Beta Rotation," shows just how important this is for those looking to not only enhance return, but also minimize risk.
For now, while markets can bounce, the odds appear to still favor that small caps get smaller. My firm's ATAC (Accelerated Time and Capital) models used for managing our mutual funds and separate accounts remain defensively positioned waiting for clearer skies. Until cyclical areas definitively lead and long-duration Treasuries stop getting bid, caution remains warranted.
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