In last week’s column, we looked at the NASDAQ Composite Index and its recent divergence from the other two major indexes — the Standard & Poor’s 500 and Dow Jones Industrial Average. The Nasdaq has been showing clear signs of weakness, just as the other two indexes have been pushing to new all-time highs, all of this occurring as earnings season and GDP growth have reflected marked weakness, as well.
As all of this has been unfolding, the Russell 2000 — the small company stock index — has been showing clear signs of a significant correction, a correction that could be a precursor to a major correction for the broader stock market.
From the March 4 high of 1,213, the Russell 2000 has declined to 1,107 as of Friday’s close, or by 106 points/8.7 percent. During the same time frame, the S&P 500 has experienced almost no change, trading sideways to 1,878 from 1,874.
Most concerning, if you happen to be long in the market, is the double bottom forming at the ~1,080 level. Should the Russell 2000 penetrate this level, we could easily see this index drop well below the critical 1,000 level.
Small companies tend to be the first to begin moving higher as recessions come to an end. This was certainly the case at the end of the recession that followed closely behind the financial crisis of 2008-2009. In fact, the Russell 2000 set an intraday low of 342 on March 9, and since has returned 255 percent, outperforming the Dow, S&P 500 and even the Nasdaq Composite during the five-year-plus bull market.
The recent, nearly 9 percent pull-back in the Russell is even more concerning since small companies tend to be the most sensitive to changing economic conditions. With the most recent measure of GDP growth for the first quarter of 2014 scarcely beating the flat line, coming in at just 0.1 percent annualized growth, it is no mystery why the Russell has shown such poor performance. What is a mystery is why the Dow and S&P 500 have been hitting new highs!
Last week’s column about the Nasdaq Composite and this week’s exploration of the Russell 2000 are part of an effort to determine market direction. We all want to know what the market will do next! As a professional portfolio manager, my business depends on my ability to make valued judgments, based on extensive analysis of historical, current and future trends. In my personal experience, when divergences occur, often the market is signaling a change in direction.
We now have both the Russell 2000 and the Nasdaq Composite diverging from the S&P 500 and Dow Jones Industrial Average. We also have weakening earnings and GDP while the major stock indexes — the Dow and S&P 500 — are setting new, all-time highs. These conflicting signals must get resolved one way or another: Either earnings and GDP will rebound, confirming that the Dow and S&P 500 have been right to continue the bull market rally, or weakness will continue, confirming that the Russell 2000 and Nasdaq Composite are correct, resulting in a sizable correction in the broader market indexes (the Dow and S&P 500).
If the Russell and Nasdaq are correct, and they are signaling a major correction, those companies that have the highest valuations, and those that have increased in price but have poor fundamentals, will be the stocks that get hit the hardest. Investors should immediately review their portfolio holdings to determine the risk of each position and take appropriate action by reducing or eliminating those positions most vulnerable to a correction in the broader market.
It is always difficult to take decisive action to sell positions that have been increasing portfolio values. However, markets do not and will not continue to advance indefinitely. The Nasdaq is trading at 35 times earnings — about twice the price-earnings ratio of the S&P 500. This means that the Nasdaq represents far more potential downside risk, should the overall market experience a serious correction, than the S&P 500.
Because the Nasdaq is technology-heavy, and the advance of technology stocks is a significant reason that the valuation of the Nasdaq is so high, we should expect to see technology stocks bear the brunt of a correction. The Russell 2000, even after an 8.7 percent correction from that March 4 high, is trading at 97 times earnings. One can easily see the risk associated with small companies, should we experience a major correction.
A prudent investor is continuously measuring and evaluating the risk/reward ratio within his or her portfolio. In the simplest terms, the stock market today reflects a very poor reward for the amount of risk involved in owning stocks. Investors should be realistic about their expectations for further upside potential from current levels and the potential for downside, and should take decisive, effective action to reduce risk and safeguard profits.