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Are Small Caps Firing Off Warning Flares?

From a historical perspective, the Russell 2000's perfomance is downright frightening


If you just pay attention to the Dow Jones Industrial Average, things look peachy. The index remains mired in a six-month-long sideways channel but continues to flirt with near new all-time highs.

The bulls have all the justifications figured out. The weather is the blame for the recent economic slowdown, in which Q1 GDP growth is on track to be revised to a -0.6% annualized growth rate according to Macroeconomic Advisors. Russian President Vladimir Putin is making diplomatic sounding noises again on Ukraine. The Q1 earnings season has been salvaged after a rough start.

And Federal Reserve chairman Janet Yellen is coming up with new and exciting excuses to keep short-term interest rates near 0% — where they’ve been perched going on six years now.

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But a quick glance over at the small caps in the Russell 2000 — which Janet Yellen in her testimony to the House of Representatives on Wednesday admitted were possibly trading at overvalued levels — suggests trouble.

What’s Wrong With the Russell 2000 and Small Caps

On Tuesday, the Russell 2000 closed below its 200-day moving average for the first time since 2012, ending an 18-month-long uptrend. This was a breakdown long in the making: There were no less than seven attempts during the past two weeks. The bulls simply couldn’t resist the selling pressure any longer.

The dichotomy is stark. And if history is any guide, it’s downright scary.

In fact, the gap that has opened up between small caps and large stocks was last seen near the very top of the past two bear markets.

According to Jason Goepfert of SentimenTrader, Tuesday was only the third time in 35 years of market history that the NYSE Composite was sitting at a 52-week high one day before the Russell 2000 dropped below both its 50- and 200-day MAs the next day.

The last two occurrences were 3/12/99 and 11/1/07.

That’s not all.

Through Wednesday, the performance differential year-to-date is quite large: The S&P 500 is up 1.6% while the Russell 2000 is down -4.6%. As a result, as highlighted by Bespoke Investment Group, the performance advantage that small caps enjoyed in 2013 has now been erased.

From the intraday high on March 4 into Wednesday’s intraday low, the Russell 2000 dropped 9.8%. Since the bull market started in 2008, there have been two other drops of this magnitude. But here’s the kicker: They selloffs didn’t end until small caps suffered declines of more than 20% (in July 2010 and October 2011).

So far, the large caps have been resisting the selling pressure. During the 2010 selloff, small caps and large caps maintained a correlation coefficient (a statistical metric that measures how closely two sets of data follow each other up and down) of .985. That means the two were 98.5% aligned. In 2011, it was .992.

But right now, it’s just .299, or 29.9%.

The $5 trillion-dollar question is: Will large caps fall to realign with small caps, or will the two go on their separate ways?

Other Issues

Moreover, small stocks aren’t the only area warning of trouble. Despite declarations that the economy is surging again after a harsh winter, U.S. Treasury bonds have been well-bid — traditionally, a sign that the bond market is pricing in trouble. As a result, 10-year yields have dropped back to the 2.6% level, down from a high of 3.05% at the end of 2013.

According to Citigroup research, the market stopped following the fundamentals in late 2012. That’s when bond market spreads disconnected from the amount of borrowing companies were doing. And it’s when stocks stopped responding to earnings revisions.

If bond investors no longer care about the creditworthiness of the companies they are giving their money to, and stock investors no longer care about the earning of the companies they are investing in … how is that anything other than a bubble?

Bottom Line

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I’ve been recommending investors play it cautiously with a focus on Treasury bonds via ETFs such as the leveraged Direxion 3x Treasury Bond Bull (TMF), which is up nearly 12% since I added it to my Edge Letter Sample Portfolio in late February.

For the more aggressive, the weakness being displayed by small-cap stocks is creating put option opportunities in stocks like Lululemon (LULU) and Coach (COH).

Put option positions recommended to clients in these names are up 240% and 411%, respectively.

Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm. As of this writing, he has recommended TMF and puts against LULU and COH to his clients.

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