The Russell 2000 Index and the Modified Davis Method

The Russell 2000 Index (RUT) has spent this year oscillating in a wide range, making very little net progress:

Russel 2000 index daily – no progress this year – click to enlarge.

The problem is that it is therefore underperforming the big cap S&P 500 ever more. Given that outperformance by the Russell has been a hallmark of the cyclical bull market since the 2009 low, this development should be of grave concern to investors.

In 1998 to 2000, big caps were also leaving small caps in the dust. At the time, their outperformance lasted about 1 ½ years and involved substantial additional gains in many big cap stocks (especially technology shares), but these things don't always play out in exactly the same manner. In fact, they almost never do. We just mention this in order to point out that it is neither provable that the warning signal will have immediate consequences, nor that it can be safely ignored. The totality of evidence suggests caution is warranted, but that has been the case for quite some time.

The ratio of RUT to SPX shows the extent to which the former has turned from a leader into a laggard – click to enlarge.

The reason why we bring the Russell up at this juncture is that Frank Roellinger, who has developed the Modified Davies Method for investing in the Russell, has just informed us that the system has gone 50% short for the first time since 2009. The system already went to cash on one occasion earlier this year, but subsequently briefly reestablished its long position. The latest development strikes us as noteworthy, mainly because the system has been highly successful thus far. You can read a backgrounder here: “The Modified Davis Method”.

As Frank informs us:

“My method finally exited the 100% long position and went 50% short at the close on Friday, 7/18 at Russell 2000 1151.61.  The sell threshold was hit with breadth divergence and that's all it takes.

 Half of the long position was established almost exactly 4 years ago at Russell 2000 519.22, making this one of the longest holdings in the method's history.  Now it's finally in step with the bears.” 

So we have an additional warning from this technical system, although one must keep in mind that it has been developed specifically for trading the Russell 2000 Index. However, even considering this caveat, it is clear that the Russell's larger degree trend probably won't be different from that of the broader market. If the index is fated to go down, the rest of the market will go down as well.

Sentiment Update

Lastly, here is an update of Rydex asset ratios which we watch as a gauge of market sentiment. Obviously, this is far from the only gauge of market sentiment available, but it has a pretty good record of identifying sentiment extremes.

There is an interesting development to report: apparently the 18 level in the bull/bear assets ratio seems to represent some sort of limit. This is as “good as it gets”, or better, “as extreme as it gets”. The level has been tested three times in a row so far this year. There has been a small blip upward in Rydex money market fund assets concurrently with the most recent decline in the ratio, they remain however at levels last seen in the late 1990s.

Rydex money market funds, the SPX, Rydex bear assets and the ratio of bull to bear assets – click to enlarge.

Conclusion:

Warning signs keep emerging. Note in this context also our recent observation on credit spreads. US true money supply growth remains quite brisk for now (above 8% y/y recently), but the pace of growth has halved from its peak and it is impossible to tell in advance where the “bust threshold” will be this time. Usually one would expect money supply growth of more than 8% annualized to continue to lend support to the market, but we cannot apodictically state that this will be the case. Which assets will attract newly printed money is never entirely certain.

Addendum: The “Zimbabwe Market”

As has been seen in Zimbabwe and elsewhere, in hyperinflation conditions, stocks will rise in terms of the devaluing currency regardless of underlying economic fundamentals. However, it would be wrong to conclude from this that price inflation is automatically “a good thing” for stocks. There is at the very least a lengthy transition period when the fact that the real value of earnings declines weighs more heavily on stocks than the repricing of assets due to devaluation. This could be observed in 1973-1974, when the market collapsed by more than 50% in spite of nominal earnings rising every single quarter during the bear market period. In other words, should inflation expectations worsen considerably (most likely not a near term prospect, but it could become a worry at some point), valuation compression will replace valuation expansion for a good while. 

Charts by: StockCharts