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Craig Allen: Russell 2000 Serves as Leading Indicator for Market Direction

With stocks trading very near to all-time highs, and with the Standard & Poor's 500 closing at all-time highs 33 times so far in 2013, market participants are becoming increasingly jittery. Valuations are very expensive at present, and as the overall level of the market rising, and valuations are extended, the risk of a correction also increases.

In an effort to identify possible signs of a change in market direction, we can look to the relationship between the S&P 500 and the Russell 2000 small-cap index — a relationship that has provided reliable guidance in the past.

Stocks ended this past week with the Dow Jones Industrial Average rising 0.3 percent, the S&P 500 Index adding 0.1 percent, the Nasdaq Composite Index dropping 0.5 percent, and the Russell 2000 losing 2 percent.

The Russell 2000, which is the small company index, tends to move early, both up and down, leading the broader market (S&P 500). Often we can get an early indication of when the market will change direction by watching the Russell 2000.

In the one-month chart nearby, we see the S&P 500 in blue and the Russell 2000 in red. This past week, we saw the Russell dramatically underperform the S&P 500, again dropping 2 percent while the S&P 500 was basically flat during the week.

Russell 2000

If we think about the relationship between the Russell and the S&P 500, it makes sense that the Russell would move first because it is an index comprised exclusively of small-capitalization companies. Small companies tend to be earlier-stage, with high growth rates, and are therefore more sensitive to economic conditions, and riskier than larger, more-established companies that make up the S&P 500, which contains roughly 80 percent large companies.

Similar to a canary in a coal mine, small company stocks tend to be highly reactive to changes in economic conditions, or to changes in investor sentiment regarding the economy and the stock market.

Nearly three-quarters of the S&P 500 companies having reported earnings so far this season. Of these, 74 percent have beaten their consensus earnings estimates, above the four-year average of 73 percent (FactSet). Revenues, however, have been far less positive, with only 53 percent of the S&P 500 companies reporting thus far surpassing consensus revenue estimates, compared with the four-year average of 59 percent (FactSet).

Earnings increases have been achieved largely through cost-cutting — including employee layoffs — rather than through growing revenues. At this late stage in the economic cycle, companies have just about exhausted their ability to cut costs. To continue to achieve earnings growth, they will need to grow their revenues. This will be much more difficult than simply cutting costs to secure growth.

The current P/E (price-to-earnings) ratio for the S&P 500 is 18.71, which is a very expensive valuation for this index. However, it pales in comparison to the 87.4 P/E for the Russell 2000. Although smaller companies tend to have higher growth rates, and therefore can command higher valuations, the current P/E for the Russell is extremely high. Few market commentators have referenced the possibility of the markets forming a bubble, but, based on these valuations, one could certainly make a case for a bubble at this point.

The Russell 2000 has gained 29 percent year-to-date, while the S&P 500 has increased 23.5 percent. From a low in March 2009, the Russell 2000 has gained 220 percent, while the S&P 500 has grown by 164 percent. These five-year gains are certainly among the most impressive of any five-year period throughout the history of the markets. We must ask ourselves how much more upside we can expect to gain from current levels.

Although the divergence between the Russell 2000’s performance and the S&P 500’s performance last week only represent a very short time frame, keeping an eye on the performance of the Russell relative to that of the S&P 500 could offer some predictive value regarding the future direction for the overall market.

In terms of drivers that could cause a correction to begin, there are many to choose from. With 80 companies out of the 500 S&P 500 companies reporting this coming week, we could see a significant negative trend in revenue reports serve as a trigger for a correction.

Any indication that the Fed will start the tapering process of its bond-buying program could also shock markets. Weak retail sales during the holiday season, the pending showdown in Congress as we once again approach the debt ceiling in January, rising interest rates, geopolitical conflicts and many other concerns — or a combination of these — could be enough to get things moving to the downside in the near-term.

While I still believe stocks represent a good long-term investment opportunity, valuations are just too expensive to put new money into the market at present. Only after a reasonable correction will valuations come down enough to provide an attractive risk/reward relationship for stocks.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your 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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