Should You Be Worried About Small-Cap Divergence?

The bull market turned three amid a fresh tide of skepticism

by 3/10/2012 9:40:03 AM
Stocks quoted in this article:

The bull market celebrated its third birthday last week in low-key style, as traders remained preoccupied with the latest Greek debt developments. Stocks once again finished the week nearly flat, having recovered -- somewhat haphazardly -- from their worst daily performance of 2012. This week, Todd Salamone takes a closer look at Tuesday's sell-off, and points out an intriguing similarity to the market's late-January pullback. And, with skepticism still surrounding the three-year-old rally, Todd puts the technical crowd's sell signal du jour to the test. On the other hand, Rocky White is marking the milestone by celebrating the best- and worst-performing sectors of the past several years. Finally, we wrap up with a preview of the major earnings and economic reports for the week ahead, as well as a few sectors of note.

Notes from the Trading Desk: Testing the Latest Technical Sell Signal
By Todd Salamone, Senior VP of Research

"When will all this fun come to an end? With the Russell 2000 index of small cap stocks hovering around one-month lows and the Dow Transports continuing to underperform, it may be sooner than expected."
- The Wall Street Journal, March 6, 2012

"The drop in small-caps in the past 30 days or so, as well as a decline in the past month in the Dow Jones Transportation Average, are divergences from the broad market that investors shouldn't ignore. There is a complacency and lethargy to the market that suggests a quick and humbling 3% to 5% pullback could be in the offing, one trader says... Investors' worries have shifted from topic to topic in the past 12 months, just as a baton passes hands in a race. The European sovereign-debt situation was enemy No. 1 last spring. The worry next turned to whether U.S. economic growth would turn flaccid. Now it has morphed into concerns about rising oil prices, what with crude above $100 per barrel."
- Barron's, March 2, 2012

We finally got "it" last week -- the pullback everyone was predicting. Or did we? The S&P 500 Index (SPX - 1,370.87) lost more than 1% last Tuesday, after 46 consecutive days without a loss of this magnitude. In the process, the benchmark index closed below its 20-day moving average for the first time since Dec. 19 -- another streak that was worrying some technicians.

But was the pullback enough? Did those on the sidelines waiting for a pullback miss an opportunity, with the SPX quickly snapping back to its February highs? For example, we know many technicians key on the 50-day moving average. However, the SPX's low occurred 13 points above the current site of the 50-day moving average, with the index finding support instead near its previous highs in 2011. Moreover, if the excerpts above represent the crowd's opinion, you've got to think that many investors are still on the sidelines waiting for a pullback of greater magnitude --somewhere in the order of 3% to 5%, or even 10%.


Daily Chart of SPX since January 2011 With 50-Day Moving Average

A risk to those waiting for a deeper pullback is that the early March decline might be all they get for now. We find it interesting that Tuesday's low marked a 38-point decline from the SPX's intraday peak of 1,378.04 on Feb. 29, matching the 38-point decline from the intraday high to intraday low that occurred Jan. 26 through Jan. 30. After the modest pullback in late January, the SPX rallied 60 points to its closing high on Feb. 28. In both cases, the 38-point SPX declines at the end of January and the beginning of March were preceded by low-volatility advances that spelled disbelief among many traders and investors.

An additional risk to the bears is that there is enough firepower on the sidelines to drive another 60-point SPX rally. For example, a survey by the National Association of Active Investment Managers (NAAIM) revealed that the average manager was only 57% net long last week, down significantly from the 74% the prior week. For perspective, optimistic extremes during the past five years have been at 85% or higher net long, which we last saw in early 2011.

This "run for the hills" attitude in the NAAIM survey is confirmed by our options data, which has shown an increase in CBOE Market Volatility Index (VIX - 17.11) put buying, and a decrease in put buying relative to call buying on major exchange-traded funds (ETFs) that we follow. Assuming the activity on VIX futures and major equity-based ETFs is hedging related, it would suggest that a bearish mentality suddenly gripped institutional fund managers ahead of the Greek debt swap last week. Continued bearishness among this group would be a negative omen for equities, and this is something we are watching vigilantly. But with the Greece event now in the past, it is quite possible that an unwinding of these bearish views takes place in the weeks ahead.

We are watching the indicator in the chart below closely, as the 20-day buy-to-open put/call ratio on the SPDR S&P 500 ETF (SPY), PowerShares QQQ Trust (QQQ), and iShares Russell 2000 Index (IWM) has turned lower, and this has had bearish implications in the past. Technical breakdowns in the SPY, QQQ, and IWM would be further alarming, but this has not occurred yet.


20-day buy-to-open put/call ratio for SPY, QQQ, and IWM

Among the many concerns voiced by technicians in recent weeks is the divergence of the Russell 2000 Index (RUT - 817.00) from the SPX. Admittedly, there are multiple ways to quantify "divergence" and, as such, the study we ran may not align with other divergence studies.

The fact is, the SPX closed at a new 12-month high on the first day of March, but the RUT was trading 1.90% below its 20-day previous high. We set up a study to see if a divergence like this has had historical bearish implications for the market. We loosened the parameters by taking instances when the SPX hit a 12-month high and the RUT was at least 1.75% below its previous 20-day high. Since 1986, the sample size is small, but bullish price action actually followed, suggesting the small-cap divergence fears could be misplaced. For those new to Monday Morning Outlook, we'll point out that over the past few weeks, similar fears about the VIX futures term structure and the percentage of stocks trading above their 50-day moving average have been misplaced, as well.


SPX-RUT divergence study

We remain bullish, as the technical backdrop of the benchmark equity indexes still looks healthy. Plus, there's short-covering potential, and sideline cash is still waiting to be deployed after only a modest pullback to begin the month. But, given the uncertainty with respect to the next major move among institutional investors, hedging your long exposure is prudent at this juncture. Our favorite sectors continue to be the homebuilders and retail/restaurants.

One final note: next week is March options expiration. Since 2000, seven of 12 March expiration weeks have been positive, with three of the past four displaying bullish price action, and the average return since 2000 arriving at 0.73%. In 2011, however, the SPX experienced a decline of 1.92%.

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