Small Cap Divergence

Well once again, the S&P500 bounced back last week, reversing the prior week’s losses and setting a new high. The S&P rose 1.25% and touched another new record high, before retreating somewhat on Friday, which was the only day of the week when volume jumped. Volatility, as expected in a week when prices rose, dipped back down to the bottom of a multi-year range that can best be described as a zone of complacency. Investors are clearly not worried about any meaningful downside risk to equity prices in the S&P500.

Technically, the charts are once again highly stretched—they suggest that the S&P is very over-bought. But given that this has been a recurring phenomenon over the last two years, once again, this condition is no longer raising any serious concerns among even some of the most seasoned long-term professional investors. To back this claim up, the percent of investment advisors who call themselves “bearish” on US equity markets remains stuck near multi-decade lows.

In terms of economic news, the big story of the week was inflation…or rather the lack of inflation. Consumer prices—both headline and core—were reported at levels far below expectations. In fact, headline inflation was negative. This suggests that wage inflation is still not even close to being a problem (and with the labor force participation rate near multi-decade lows, this is no surprise) and that now even the goods market (as opposed to the labor market) is slowing down in terms of price pressure. Adding to the slow-growth thesis was the industrial production result—instead of rising 0.3% as expected, it dropped 0.1%. Housing starts also missed…..badly, as did leading indicators. On the positive side, initial jobless claims fell below 300,000 and the Empire State Manufacturing Index beat expectations.

Finally, an interesting development is occurring in the small cap stock indices (eg. Russell 2000)—in direct contrast to what’s happening in the large cap indices (eg. S&P500).

While the S&P trudges on to greater and greater heights, the Russell 2000 finished last week in the RED for the year! On top of that, the Russell is about to complete a very bearish formation called the Death Cross—where the 50 day moving average crosses below the 200 day moving average. For most market technicians ¬†(based upon decades and decades of history) this is one of the key signals that a bear market is starting in an index.

In terms of what this means for the S&P500, this is a major bearish divergence. This means that while some key leadership stocks keep propping up the major market index (the S&P) most stocks in the US—or the thousands of small caps—are dropping and entering bear market levels, when they’ve fallen by 20% or more from their most recent highs.

This divergence is resolved in only two ways—either the small caps reverse course and leap back up to match the lofty heights of the S&P500…..or……the S&P500 converges with the Russell 2000 by dropping down to match it.

Historically, the most common way this divergence was resolved was with the Russell leading and the S&P following. Did it ALWAYS happen this way? No…..but in the vast majority of times, it did. Let’s see what happens this time.

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