Wednesday, December 10, 2014

Revisiting Divergences

In our September 24th post, we offered the following commentary and accompanying chart as we looked at the divergences taking place between small cap stocks and large caps:

However, what worries us is the clear divergence between small caps and large caps.  The folks at Nautilus Research (@NautilusCap) help sum this up with the data shown below.  It looks at the instances where the S&P has proceeded to climb (up > 5% in a 6 month period) while the Russell is retreating on a relative basis (RTY/SPX Declines > 10% over the same 6 month period).  To summarize, the data portends to the Russell and the S&P struggling over the next couple of months and considerably underperforming relative to their historical trajectories.

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So we're almost at the 3 month mark of the most recent iteration of this specific RTY/SPX divergence and while each index is up a fair amount since that point (SPY +1.6%, RTY +3.2%), we've seen some pretty dramatic volatility in each.  Almost on cue, the S&P followed the Russell on its descent before each bottomed out in mid-October. Quickly thereafter, the S&P shot to new highs and the Russell recaptured positive territory for the year.  However, each has traded in a sideways chop over the last month and volatility perked back up this week with oil plunging.  So now what?  We're not sure and hence why we revisit this study.  For all of the favorable seasonality and sentiment measures we have going into year-end it's nice to have some contrasting data (albeit small sample size) to keep the good vibes in check.  Looking out to the 6 month marker, expected/average returns in this scenario continue to look fairly uninspiring.

Speaking of the Russell 2K, we're scratching our head at its recent underperformance.   With the strength in the US dollar one would think this would favor small cap companies with a more domestic focus vs large cap multinationals.  We thought this might be enough to break the divergence.  However, the exact opposite has happened and money has continued to rotate out of small caps and into larger cap names.  Perhaps after last year's surge in small caps the relative weakness this year could be wringing out the excesses.  Will money continue to flow to safer larger cap companies with stronger balance sheets or will smaller cap higher growth companies reverse their current weakness and start to exert some leadership?  Only time will tell.

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

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