The Russell 2000 Small-Cap Index is presently running into a confluence of key resistance points.

We’ve talked quite a bit about the importance of the rotation that we’ve seen in the stock market since the rally kicked off in February. Specifically, previously lagging areas of the market picked up the slack in early April when the rally was looking tired. Well, the same rotation trend has continued amid the bounce off of the May lows of a few weeks ago. Among the leaders during this current bounce have been small-cap stocks. However, they are currently up against a stiff test of resistance as today’s Chart Of The Day of the Russell 2000 Small-Cap Index (RUT) reveals.

On the positive side, the RUT has clearly surpassed its April high of 1154.15. However, there are multiple lines of resistance just above there, which the index is presently bumping into.

The potential levels of resistance near here include these big 3:

The underside of the post-2009 Up trendline (broken on January 6), currently ~1161

The 61.8% Fibonacci Retracement of the June 2015-February 2016 decline ~1162

The 500-day (~100-week) simple moving average, currently ~1164

Each of these levels represent considerable hurdles on their own. The fact that they all converge here makes the area all the more challenging.

On the other side of that coin, though, is opportunity -- should the RUT break through the 1160-1164 area. That development would open up further -- potentially significant -- upside. On a preliminary basis, the index may be in the process of doing just that as a late-day rally saw the RUT accelerate to the upside upon breaking above 1164. It was able to close the day at 1170.58.

Does that mean that the bulls have passed the test? The way modern markets work, it is much too soon for them to declare victory, in our view. There needs to be follow-through by the index lest we witness another false breakout. So let’s just say the test isn’t over yet. However, given the close above the aforementioned key resistance, the bulls have at least aced the first portion of the test going into the essay.

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Despite glowing breadth statistics during the recent rally, the micro-cap space is one area that hasn’t kept pace.

When considering the “quality” of the post-February stock rally, one of the biggest positives has been the excellent breadth. It remains to be seen whether it will provide the springboard for a longer-term advance -- or if it was merely a display of mean-reversion, given the broad market’s gross under-performance during the 6 months prior. However, no one can reasonably complain about a lack of participation. Of some concern, though, there is one area that has struggled to keep up with the broad rally: micro-caps.

Comprising some of the smallest of the listed companies in the U.S. market, micro-caps have notably lagged their peers of late, even the traditional small-caps. Yes, the group, as measured by the iShares Russell Micro-Cap ETF (ticker, IWC), has rallied roughly 13% from its February low to its recent rally high, almost exactly in line with the rally in the SPDR S&P 500 Large-Cap ETF (ticker, SPY). However, given the significantly higher beta of micro-cap stocks, the bounce certainly should have well exceeded that of the SPY.

Quantitatively, consider what that 13% move represents. For the SPY, the 13% equates to a 73% retracement of the decline from last May to February, and a 78% retracement of the decline since November. The same 13% rally in the IWC only retraced 32% of its decline since June and 44% of the decline since December. That is not keeping pace.

Another way to measure micro-cap performance is simply via a performance ratio versus the SPY. When the IWC:SPY ratio is rising, micro-caps are out-performing. When the line is dropping, micro-caps are under-performing. After peaking in early 2014, the ratio has dropped considerably. And after hitting a lower high in June, the IWC:SPY ratio dropped precipitously, indicating the severe under-performance of the micro-caps. By December, it had hit a new low since 2009.

After dropping into the low in February, the ratio bounced a bit in the early stages of the recent rally. However, unlike other broad small-cap and mid-cap averages that saw their post-February strength persist, the micro-cap rally has petered out. In fact, the lagging in micro-cap stocks has been so egregious that the IWC:SPY has already found itself back at a 7-year low.

So what’s the big deal if micro-caps are under-performing? Well for one, it presents a bit of counter-evidence to the “strong breadth thrust” case. Furthermore, the relative performance of micro-caps, like any high-beta sector, can serve as an indication of the willingness of investors to take on risk. As the chart shows, the IWC:SPY ratio generally trended upward during the favorable markets from the 2009 low into 2011 and from the 2011 low into 2014. Conversely, the ratio has traditionally fallen during “risk-off” periods in the market, most notably from 2007-2009.

The point is that, at least based on the relative performance of micro-caps, the investment landscape may not be as optimistic as the strong breadth and momentum since February might suggest. Yes, it is only a small segment of the equity market. But if micro-caps can’t get off the mat here, it may be an indication that investors are not willing to fully take on risk yet -- putting any hopes of a durable rally on hold.

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Muhammad Ali photo from Daily Mirror.

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December pullbacks in small-caps have led to extraordinarily favorable returns into year-end.

This post is an addendum to our piece on Monday regarding the strong December seasonality for small-caps. If you recall, since 1991, 21 of 24 years have seen the Russell 2000 (RUT) small-cap index close higher in December. And only 2002 saw the index close lower by at least 1%. Given the selloff in equities over the past 2 days, we thought we might expand on the topic by exploring the performance of small-caps following drawdowns within the month of December. Now, given the fact that 7 out of 8 Decembers see positive small-cap returns, it doesn’t take a rocket scientist to figure out that year-end returns following days when the RUT is down month-to-date are also strong. We thought we might provide a little color, though, just to drive home the point.

First off, from 1991 through 2014, the Russell 2000 has been lower month-to-date for December on 157 days spanning 20 different years. While the amount by which the RUT was lower and the point in the month when the index was lower both vary widely across all of the instances, one thing has been consistent. The Russell 2000 has been higher at year-end following the vast majority of the days.

In this first chart, we show just how strong -- and consistently strong -- the Russell 2000 has been in recovering from these December losses. The chart divides up all of the days on which the Russell 2000 closed lower month-to-date in December by the amount they were down. It measures both the median return from those days until the year-end and the percentage of days that closed higher at year-end.

Almost across the board, the Russell 2000 has had a tendency to close the year sharply higher than where it stood on the day of its drawdown. The median return from such days into year-end is over 3% for all categories covering smaller than 0.2% losses up to 4% losses. The median return following intra-month losses of between 3% and 4% has been an impressive 5.24%. Only those losses greater than 4% saw the index struggle to make gains by year-end. So, perhaps it would behoove investors to have the Russell 2000 stay above that -4% threshold.

Furthermore, the consistency of the gains by year-end has been remarkable. Note, for example, that all 49 days exhibiting a month-date loss of between 0.2% and 1% closed the year higher. And 36 out of 37 days showing a December month-to-date loss of between 2%-3% ended the year higher.

What’s more is that, removing the RUT’s poor showing in December 2002, we see that every single day in a December since 1991 that saw a month-to-date loss of at least 0.2% finished the year higher. For the record, that would be 124 winners at year-end out of 124 days.

To illustrate, here is a chart showing the year-end returns of all 142 days, including 2002, that saw the Russell 2000 down for the month of December by at least 0.2%. The only 18 days that did not close the year higher were those in 2002. All 124 other days finished higher at year-end.

Now, hopefully I do not need to remind anyone that past performance is no guarantee of future results. Just because the Russell 2000 closed today at -2.3% for the month of December, it is not a lock to be higher at the end of the year. That said, over the last 25 years the seasonal tendency of small-caps to perform strongly and resiliently in the month of December is unmistakable.

At some point during this holiday season, you are likely to hear the phrase “good things come in small packages” (I know I’ll definitely hear it). For investors, if the historical pattern remains true, they may very well be getting a gift right now wrapped in a small-cap package.

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After the initial pop off the September low, small-cap stocks have significantly under-performed their larger peers -- is that trend as troublesome as some are claiming?

If you are closely involved with markets, you know that there are always items of concern among participants. One such concern presently is the recent under-performance on the part of small-cap stocks. In the initial ramp off of the late-September lows, small-caps performed in line or better than larger cap stocks. However, since that first week or so of the surge, smaller stocks have lagged, even as large-caps have continued to score higher highs. This has some observers worried about the “quality” of the current rally. Are those concerns warranted? We took a closer look at the situation to see if we couldn’t find a few clues.

First off, what sort of under-performance are we talking about on the part of small-caps? Well, the first pop off of the September “re-test” lows lasted about 7 days, rallying all of the indices by about 6-8%. In the roughly 2 weeks since, however, there has been quite a bifurcation in the performance of the various indices. The S&P 500 large-cap index, for example, has continued to advance, rallying nearly 3% over that time. Meanwhile, the Russell 2000 small-cap index is essentially unchanged. That dynamic has some folks worried that the rally may have run its course. Let’s check it out.

Since 1991, we have found 75 previous days in which the S&P 500 showed a 2-week gain of at least 2% while the Russell 2000 gained no better than 0.5%. We took those results and drilled down further, looking for instances that in some way matched our present circumstances. We zeroed in on 2 sets of circumstances to see if there was anything consistent in the market performance following such events.

  As the chart shows, one of the factors we looked for were times, like now, when stocks were coming off of a 6-month low some time over the past month, at least in the Russell 2000. We found 20 such prior events (shown as blue dots on the chart). So did the Russell 2000 put a halt to the bounce? Not in the slightest.

Both the S&P 500 and the Russell 2000 consistently rallied in the subsequent week to 6 months. The 1-week marker was especially consistent as 18 of the 20 events showed a positive return in the of the indices. In terms of return, both indices showed stellar figures, peaking at the 3-month mark at a median +6.7% and +13.7% for the S&P 500 and Russell 2000, respectively. Needless to say, the small-cap under-performance did nothing to thwart the budding intermediate-term rallies.

It is worth noting one thing, however. Several of these occurrences were inclusive of the 6-month low within the measuring period. That is, the 6-month low took place during the S&P 500′s 2-week rally and the Russell 2000′s under-performance. That is a bit different than our present situation. The 6-month market bottom took place several weeks ago and, subsequently, both indices enjoyed a nice bounce. Thus, the 2-week measuring period has taken place after that initial bounce.

Looking at the data, those examples in which the 6-month low occurred prior to the past 2 weeks did not fare as well as the larger sample. In fact, 5 of the 6 2-month losses in both the S&P 500 and the Russell 2000 were accounted for by those occurrences when the market had bottomed prior to the past 2 weeks. Long story short -- the current set-up has not been quite as bullish as those instances that included the 6-month low day in the 2-week measuring period.

Also along those “not so fast” lines comes our other study factor. We looked at those times in which the S&P 500 sat at a 2-month high following its 2-week rally (as was the case on Friday). The returns were not quite as promising. In fact, they were downright lousy.

The median return was negative from 2 weeks out to 2 months for the S&P 500, and from 1 week to 3 months for the Russell 2000. And while the Russell 2000 led way higher in the previous table, it led the way lower here, bottoming out at a median loss of -6.7% 2 months out.

So which of these studies will set the precedent for our present case? Unfortunately, the present case is the only occurrence meeting the criteria for inclusion in both categories. Therefore, in a way, it has no precedent. If we had to pick one period that showed perhaps the most similarities, it may be late November 1998. The indices had bounced strongly off of a re-test low before the under-performance of the small-caps began. While the S&P 500 was at a 2-month high, it had narrowly missed forming a 6-month low the month before. For what it’s worth, both indices were lower 3 weeks later before rebounding over the longer-term.

So is the hand-wringing over the laggard small-cap space justified? We frankly did not know so we examined the issue. Upon further inspection...we are still not sure as the results were quite conflicting. Like we have said before, however, at least now we know what we don’t know -- and even have a reason for why we don’t know. That’s always better than assuming you do know.

You know?

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One survey recently recorded the highest level of expectations for a market rally in its (admittedly brief) history.

Not too long ago, stock market bulls were fond of dubbing this cyclical rally “the most hated bull market in history”. The premise was that, despite the considerable gains accrued by the market since the 2009 lows, investors were relatively slow to embrace the rally. We would say that based on various money flow and sentiment metrics, there was probably some truth to that notion, up until perhaps mid-2013. Since then, we have seen a notable pickup in investors’ collective “embrace” of stocks. In fact, according to the University of Michigan’s Survey of Consumers, respondents’ expectations for a stock market rally have never been higher than they were in June. That should be a red flag from a contrarian sentiment basis.

As shown in the chart, the UM survey asks people for their “probability of an increase in the stock market in the next year”. Taking the mean response to that question, June’s reading of 63.1 is the highest ever recorded in their survey, surpassing the previous record of 62.2 from July 2007. So much for the most hated rally in history.

Okay, okay, so the data series has only been around since 2002, giving us just 2 cyclical bull markets in which to judge. We fully acknowledge that and acknowledge the unqualified hyperbole of this post’s title. Let that be a preemptive admission for the flood of feedback waiting to point that out. However, technically, the title is accurate.

Another interesting view of the survey comes from a look at the extreme responses rather than the mean. When tallying the survey results, the UM breaks the responses down by quartiles (i.e., the % of respondents expressing a probability between 1%-24%, 25%-49%, etc.). They also provide the percentage of respondents who say there is a 0% chance of a stock market rally over the following year as well as the percentage of respondents saying there is a 100% chance. Not surprisingly, a high level of these respective responses have come at interesting junctures, i.e., the wrong junctures.

Here are the months in which at least 10% of respondents said there was a 0% chance of a market rally over the next year:

March 2003 (10%)

February 2009 (10%)

March 2009 (10%)

Obviously, those are the dates of the previous two cyclical market bottoms.

Here are the months in which at least 10% of respondents said there was a 100% chance of a market rally over the next year:

February 2004 (12%)

July 2007 (10%)

September 2007 (10%)

November 2007 (11%)

May 2013 (10%)

June 2013 (10%)

March 2014 (10%)

January 2015 (11%)

February 2015 (10%)

June 2015 (11%)

The dates in 2007 obviously occurred as the market was putting in a cyclical top. The rest of the months did occur during bull markets, so that gives hope in light of the recent reading that the rally can continue. However, even after those intra-bull market readings, stocks did struggle in the months following.

That even includes the bevy of readings occurring over the past few years, despite the strong general rally. And while these respondents may represent a relatively few bullish die-hards, the readings do lend more evidence against the “most hated bull market” argument.

Speaking of struggling in the months following, we have obviously seen that again since the June spike in “100% respondents”. Given the recent crash-like action in the stock market, that short-term tendency to struggle following such readings has been satisfied. But what about the longer-term?

We don’t have the reading for August so we don’t know how much of the excess has been wrung out of this survey. However, as the buildup in this sentiment series has taken years to accomplish, it is unlikely that a full correction of the excess can take place in 1, albeit historically volatile, down month. If indeed a cyclical top in stocks has been formed, or is in the process of forming, this data series will likely require either a greater crash or, more likely, much more time to fully correct its bullish excess. We would not be surprised if such a scenario unfolded.

If that’s the case, you’ll really see what a hated market looks like. 

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One question that seems to come up rather frequently is, “when will the current bull market most likely come to an end?” Now in its seventh year, the current bull market is DJIA’s fourth longest using the standard bear market definition of a 20% decline, but it is only the fifth best by gain. Well, absent a fully functioning time machine, no one really knows. All that can really be done is compare the ends of past bull markets with present day conditions in an effort to identify some early warning signs. 

One sign that has appeared this year is the outperformance of small-cap stocks when compared to large-cap stocks. An easy comparison can be represented by simply taking the Russell 2000 and dividing it by the Russell 1000 as found on the bottom of page 110 of the Stock Trader’s Almanac 2015. A similar chart appears next.

After underperforming the S&P500 for most of last year, the Russell2000 is approaching an important breakout level relative to its large-cap counterparts. Here is a daily ratio chart of the Russell2000 ETF $IWM vs the S&P500 ETF $SPY. Late last year, the ratio broke above its downtrend line from the highs last year. The next step is to start to put in higher highs. A break above the January highs would confirm that.

What does this mean? Bigger picture it's hard to take outperformance out of the "riskier" smaller-cap names as a bad thing. If there is real risk appetite out there for US Equities, we want to see money flowing into small-caps at a faster rate than into the less volatile, larger-cap stocks.

Aside from the broader market implications, a pair trade where one short the S&P500 in equivalent nominal amounts to being long the Russell2000, a breakout above this resistance would trigger that opportunity. Risk management-wise, I see no reason to be in this particular pair trade if the ratio is below the late January highs.

This is an interesting chart to watch. I came into the year looking for small and mid-cap stocks to outperform the large-caps. So far we are seeing this outperformance as we close out the first quarter. Moving forward, a breakout here would confirm this trend is likely here to stay.

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We have discussed measures of market sentiment on many occasion. These measures take the pulse of the collective mood on the part of a particular investor group. Sentiment is merely a function of human nature and when it becomes one-sided, it is an indication that the tide is due to turn. In general, when such measures reach an extreme in bullishness, the market typically struggles afterward. Conversely, when bearishness becomes pervasive, the market is prone to rally.

As we have mentioned before, there are two different types of sentiment indicators: surveys and real-money indicators. Surveys ask respondents how they feel about the market's prospects, whereas real-money gauges reveal what investors are actually doing with their money. We prefer the real-money measures as they are more reliable. Money talks, as they say.

One such real-money measure of sentiment regarding the stock market is the amount of money allocated to bearish instruments, whether as hedges or outright downside bets. One of the categories of bearish instruments we track is that of "inverse" or bearish mutual funds, i.e., funds that go up when the market goes down. One of the oldest providers of beaish mutual funds is the Rydex family of funds, now owned by Guggenheim. We like tracking the amount of assets in these funds as a gauge of sentiment, particularly given the amount of history behind them. That history makes the fact all the more significant that the number of assets in Rydex bearish funds yesterday sank to an all-time low.

Specifically, the series in the chart consists of the combined assets of the 4 Rydex bearish funds that have existed since 2000. That figure dropped yesterday to just $112 million. For reference, the all-time high was set in February 2002 at $2.1 billion. This indicates that A) traders and investors in mutual funds have little concern regarding the prospects of a market decline and B) their portfolios are ill-equipped to handle such a decline.

Now, with every study there come caveats or mitigating factors to the message. It is no different with this data point. First, and most importantly, there has been a structural decline in the amount of assets in inverse mutual funds over the past decade. This is due directly to the proliferation and growing popularity of inverse ETF's. More traders are opting for ETF's as a hedging vehicle than mutual funds. That is a big reason for the all-time low in Rydex bearish funds.

That said, there are shorter-term fluctuations in these assets that still make the gauge useful as a sentiment indicator. For instance, as recently as October, these assets were nearly double what they are now. A year prior, they were triple what they are now. And as recently as the fall of 2011, these funds had nearly $700 million allocated to them.

Another (slightly) mitigating factor is that bullish assets have also come down just recently. In fact, they are down some 25% from their high in late November when we last highlighted Rydex assets. However, that still leaves them near 7-year highs, so that's not a whole lot of comfort for the bulls.

The takeaway is pretty simple. While there has been a structural trend away from inverse mutual funds and toward inverse ETF's, this is still a milestone low in the amount of assets in Rydex bear funds. Adjusted for that structural change or not, an all-time low is an all-time low. Furthermore, we have not witnessed a relative recent surge in the amount of bearish ETF assets. Therefore, the conclusion has to be that investors are likely very poorly positioned currently as it relates to their ability to withstand a significant market decline.

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Photo by Ron Niebrugge, WildNatureImages.com