US Small Caps act as canary in coal mine for the wider market…

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In another classic sign of the market topping, the leaders of the long bull run – US small cap and technology stocks continue to implode while the headline indices like the Dow Jones Industrials and the S&P 500 remain stubbornly near their record highs.

This is typical of a market rollover pattern. The smart money has, it seems, already left the building (see chart below) and the sale of shares in highly valued IPO’s is already coming back to haunt those funds and investors that so eagerly chased prices that the real clever chaps (the founders and early stage backers) were so eager to sell. Twitter being a prime example. From highs in the mid $70’s at the turn of the year, the shares traded as low as $29.50 yesterday. That is one severe retracement. Reality is coming home to roost.

In another example of the old saying – “lies, damned lies and statistics”, the benchmark small cap index the Russell 2000 belies the reality of what is happening beneath the market, with returns sheets relaying that it is up more than 16% from one year ago. However, from making new highs at the turn of the year, it is now down 4% YTD. The optimists hope this is a small break to take in fresh air (mugs?) before rising into new highs. With a PE multiple that had been approaching triple digits, we will not be buying any return new highs.

The problem with indices is that they take weighted averages of several share prices and in the Dow’s case it is actually an arithmetically weighted one, that being that higher dollar priced stocks have a disproportionate effect on the index rather than the market capitalisation and which is a more accurate reflector of what is actually happening with corporate stock collectively.

With the Russell 2000 index, although being weighted appropriately by market cap and not dollar price, a few resilient large caps may thus be enough to mask the underlying trend followed by the majority of other components. In the case of Russell, the index is a weighted average of, yes you guessed it, 2000 different share prices but with some top heavy constituents that are skewing the returns figures

The reality of the matter is that almost half of the index, some 967 of the 2000 components are in a bear market. A bear market definition being a retracement of 20% from their 52-week highs. So what is happening? It is quite simple, the change in monetary policy to continued tapering and tightening on the horizon in the UK & the US has caused a shift away from the momentum, arguably higher risk and richly valued stocks. The routing in the biotech sector that has also fallen sharply is the most acute example of this followed by tech stocks.

More worrying, while the small caps are acting as the canary in the coal mine, sadly the retail investor keeps buying as the chart below shows. In fact, the retail investor is taking up their traditional role, that of cannon fodder: helping institutional investors to quietly unfold their positions!

Head in the send from retail purchases perspective and a sharp decline in small caps are two bearish signals that we should carefully look at. It is time to enter the market but as a seller, not as a buyer!

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