Beware of the Russell 2000, but should you buy the Dow Jones Industrial Average?

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There has been a bifurcation in the U.S. stock market recently.

This is unusual because, typically, markets move in relative tandem. This time, however, the four major markets in the U.S. are not moving the same way, and it’s important for us to understand the differences. If we can identify the differences, we may just be able to identify opportunities as well, but it may not be what you think.

The four major markets are the Dow Jones Industrial Average DJIA, +0.49% S&P 500 Index SPX, +0.19% Nasdaq 100 Index NDX, -0.28% and Russell 2000 Index RUT, -0.20% Some might argue that the Nasdaq Composite Index COMP, -0.26%  is more important than the Nasdaq 100, but the Nasdaq Composite also has many small-cap stocks that are already included in the Russell 2000, so the Nasdaq 100 is a better indicator overall.

With that, the Russell 2000 and the Nasdaq 100 are higher-beta markets, but with one material difference. The Nasdaq 100 is composed of some of the biggest companies in the market, including Apple AAPL, -0.29% Amazon AMZN, -0.84% Microsoft MSFT, -0.72% Intel INTC, +0.59% and other stocks with large market caps and huge daily trading volumes. The Nasdaq 100 is, therefore, an incredibly liquid market, while the Russell 2000 is not.

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The small-cap composition of the Russell 2000 has pushed up the index recently, but it is also the reason investors should be concerned. The stocks included in the Russell 2000 have lower trading volume, and therefore a big buyer or a big seller can easily move the stock prices aggressively, much more than they ever could in any of the other markets.

Russell 2000 volatility

My experience has taught me that the Russell 2000 can increase aggressively, and fall equally aggressively, sometimes like a stretched rubber band. That means when it starts to fall, it can fall very quickly.

Recently, the Russell 2000 has increased aggressively, and the rationale is rooted in a combination of tax benefits and perceived shelters. For example, where the Dow Jones Industrial Average might be hurt by international trade wars, the Russell 2000 is perceived to be sheltered. It’s not. It will be hurt if that happens as well, but maybe not as much, and that’s where the perceived shelter comes from.

The problem, however, reverts to liquidity. I have pointed out that central banks are going to drain $70 billion from the global economy on a monthly basis starting in July. The stimulus infusions that existed over the past eight years caused a trickle-down influence on stocks and real estate, in addition to bonds, and the opposite will happen as the biggest players in the room reduce their balance sheets and unwind their programs.

Liquidity = demand

Liquidity is another word for demand, so this suggests that demand for stocks will decline as well. Elasticity can be clear and present in a very unpopular way for investors in the Russell 2000 today. The Russell 2000 is already a relatively illiquid market, but global-liquidity drains will be a compounding influence.

What’s more, the Russell 2000 is testing a longer-term resistance line, and if it fails, a 10% decline in the Russell 2000 can be expected.

However, keeping with the bifurcation theme, the Dow Jones Industrial Average has been much weaker, and that has had a greater influence on our Sentiment Table. The Sentiment Table (see it on our website) identifies near-term overbought and oversold conditions, and it has recently begun to come much closer to signaling oversold. That would be a buy signal. The eight-day decline in the Dow Jones Industrial Average is part of the reason why it is approaching a near-term oversold condition, but it’s happening when the Russell 2000 is flashing warning signs.

Bifurcations in our stock market today are tangible, and they may not go away immediately. Respect the red flags in the Russell 2000, though, and don’t be a “bull in the headlights.”

Thomas H. Kee Jr. is a former Morgan Stanley broker and founder of Stock Traders Daily.