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Craig Allen: Russell 2000 Index Continues to Scream Correction

The Russell 2000 Index, symbol RUT, although still ahead by about 200 points from where it started that 12-month period, has shown serious technical sell signals, including a double top formation, and breaks of the 20-day, 50-day and 200-day moving averages.

Looking ahead, the 50-day moving average is dangerously close to crossing below the 200-day moving average. Should this occur, history tells us that small-cap stocks should go into a prolonged downtrend. Although continuing weakness in small-caps looks likely, what should we expect from large-caps, which to-date have held-up comparatively well?

Although we did see a 1 percent bounce in the Russell 2000 on Friday, when the Dow Jones Industrial Average, Standard & Poor’s 500 and NASDAQ indexes rebounded nicely, the Russell has materially underperformed the other major indexes. Since hitting a peak (which also represents a double top formation) of 1,208 on July 3, the Russell 2000 has fallen by 77 points, or by 6.4 percent through Friday’s close.

In contrast, the S&P 500 continued to post strong performance, hitting a new, all-time high of 1,988 on July 24, before pulling back somewhat (but not nearly as much as the Russell 2000) to close last week at 1,932, or down by only 2.8 percent. Further, the S&P 500 is up 4.5 percent year-to-date, while the Russell 2000 is down 2.7 percent during the same period.

Some will argue that we are witnessing a simple rotation out of small-caps and into large-caps, which is quite typical of a late-stage bull market, since small-caps tend to begin their advance before large-caps, as a new bull market begins. One problem with this argument is the performance of the Dow, which is down only slightly year-to-date after Friday’s 185-point rebound, but in comparison to the S&P 500 is certainly not showing healthy signs of growth.

Another major concern for me is that the defensive sectors of the economy have now taken a leadership position in the stock market. The health-care sector, for example, has advanced 8.7 percent year-to-date, far outperforming the S&P 500 (again up about 4.5 percent year-to-date). In comparison, the technology sector is up less — though only slightly so — by 8.5 percent.

In a healthy bull market-driven by an economic recovery, we would expect to see technology stocks leading the market higher, with the stocks that make up this sector experiencing some of the highest growth rates for revenues and earnings, and therefore demanding much higher valuations and by extension prices. This is clearly not what we are seeing today.

Before Friday’s rebound, the Dow was actually down 1.3 percent year-to-date. Although the Dow is comprised on just 30 stocks, it is a bellwether index that most market participants watch and react to in terms of their investment decision-making process. The Dow, like the Russell 2000 and the high-yield bond market, is flashing bright red at present, warning investors that a change in market direction is imminent.

With all the warning signs listed above, it is clear that investors are still viewing any pullbacks in the stock market as buying opportunities (this is why we saw the bounce Friday). We have had 27 new highs for the S&P 500 thus far in 2014, and most of these were preceded by a pullback of some magnitude. Investors are clearly not concerned about the technical damage to the market indices listed above, valuations, the political conflicts in Gaza, Ukraine and now Iraq, the default of Argentina on its bonds, or the Fed’s pending interest rate increases and the end to quantitative easing (the Fed’s bond-buying program that has swelled its balance sheet to more than $4 trillion).

Not even a lackluster earnings season for the second quarter of 2014, which to-date has not squared with the initial GDP growth estimate of 4 percent annualized growth — judging by the revenue and earnings reports we have received, growth looks a lot closer to the 1 percent to 2 percent range.

What will it take to switch investors from greed to fear  It is not clear what will need to happen to force investors to adjust their seemingly complete complacence toward assuming outsized risk. The signs are glaringly obvious, yet investors continue to invest more money into risky assets (stocks).

The longer this condition continues, the greater the risk of not just a correction of 10 percent to 20 percent, but a full-blown crash that could send the S&P 500 down as much as 40 percent (similar to what occurred in 1987). For anyone who believes this could not happen, I am a great believer in history, and when it comes to the stock market, history always repeats itself.

Craig Allen, CFA, CFP, CIMA, is president of Allen Wealth Management and founder of Dump That Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.

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