Diary of a Financier

SPX/RUT Divergence

In Capital Markets on Tue 13 Mar 2012 at 22:53

Last week, I commented on the correlation breakdown between small and large cap stocks:

I have found it interesting to watch the increasing divide between Small-Caps (IWM) and Large-Caps (SPY). SPY kept chugging higher in February. At the beginning of the month, IWM hit its high, formed a rounded-top, then slid all the way into today’s close. I rarely see this kind of prolonged, inverse correlation between broad equity indices–mind you we’re not talking different sectors, just different market capitalizations. Since February 3, IWM -5.4% v. SPY +0.2%…

I could easily blame the Apple (AAPL) effect for the divergence, but risk assets around the globe rallied through February too, leaving small-caps in the dust. I don’t consider the IWM/SPY decoupling an alarming market anomaly. Rather, US Beta had simply grown overbought. I do take note of the hiccup though, and it tells me that fundamental equilibrium lay somewhere south of IWM’s ~$83 top^. Earnings and outlooks will have to substantiate a higher valuation in April.

The divergence has widened even further since that entry, so I decided to evaluate what history has to say about such a breakdown. I used a weekly chart overlay of SPX & RUT since the 2000s bear market began, and I added the pair’s rolling 4-week correlation:

SPX v RUT (weekly)- every time correlation drops below zero with RUT lagging SPX, stocks correct.

Looking at the blue correlation curve at the botom of that chart, I notice that stocks always correct once the SPX/RUT correlation turns negative. (The one exception was December 2005, when negative correlation was a result of RUT outperforming, as opposed to the other periods, when RUT had lagged SPX.)

On StockTwits today, I mentioned how the underperformance of Small Caps & Beta has hampered our performance. The environment is risk-on, no? Am I to take this RUT hiccup as more of an alarm than previously thought? Is this a jittery rotation from Beta to blue chips?

While I still plan to hedge my long book for March 19th’s ISDA Greek CDS settlement, the aggregate of my analyses has me still expecting “March to go out like a lion.” I still expect to overweight risk right up until earnings calls start in the second week of April, at which time I should get a chance to recycle some of my HY bond gains toward buying the dip.

–Romeo

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  1. […] the other hand, I’ve honed my focus more on 1q2011′s guidance in evaluating Small Caps and Transports.  The data and the story around that time-period seem a snug fit.  When I noticed […]

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