Harbinger of a Stock Market Correction?

There is something wrong with this latest move upward in the U.S. stock market that began in the fall of 2011. Granted, U.S. stocks have been struggling over the last few months, but the rise that took place between October 2011 and April 2012 has a distinctly uncomfortable feel about it, as key indicators within the stock market are signaling that this move up is not to be trusted.

Let me explain, dear reader.

The Russell 2000 Index, which represents the smallest listed companies here in the U.S., is a key indicator for the stock market. The Russell 2000 Index includes all industries within the U.S. economy and so does not discriminate by industry, but rather by the size of the firm in relation to the large corporations that trade in the S&P 500.

When there is a bull market in stocks, it is the Russell 2000 Index that usually leads the way, as this key indicator is reflective of risk-taking. Almost all rises in the S&P 500 are led first by the Russell 2000 Index. The reason for this is that when investors perceive that the U.S. economy is on the mend and profits begin growing, the companies that will benefit from a strong U.S. economy first, and experience the biggest increase in revenue, are the small U.S. corporations.

The S&P MidCap 400, another key indicator, represents the mid-sized corporations listed on the U.S. stock exchanges. These companies generate most of their revenue from the U.S. They are not as small as the Russell 2000 companies and not as large as the big corporations that trade on the S&P 500. These companies usually outperform the S&P 500 in a bull market, because they will benefit most from a strong U.S. economy.

Here is a chart of the S&P 500, the Russell 2000, and the S&P MidCap 400 for the last 18 months:

S&P 500 ChartChart courtesy of www.StockCharts.com

Notice that, at the beginning of the chart, both the Russell 2000 and the S&P MidCap 400 are both outperforming the S&P 500. This is what normally happens in a market advance, a key indicator that the advance has sustainability. This advance, at the beginning of the chart, began in 2010.

Notice that, as we approach 2012, it is the S&P 500 that is outperforming both the Russell 2000 and the S&P MidCap 400. At the end of the chart is July 13, 2012, when it is clearly shown that the S&P 500 is outperforming the Russell 2000 and S&P MidCap 400.

This key indicator is indicative of a few things.

First, I have written about the money sitting on the balance sheets of the large corporations within the S&P 500. These large multinationals are able to diversify their revenue with countries throughout the world. Investors have clearly preferred them and the S&P 500 recently to the smaller companies.

However, this is very unusual behavior, because real bull markets are usually led by the Russell 2000 and the mid-sized firms; but, in this case, it is the S&P 500 that is leading, which makes me suspect that something is wrong with this market advance.

Secondly, if small- and mid-sized corporations are underperforming the S&P 500, it means investors don’t have confidence in the U.S. economy and would rather invest in multinational firms…the same multinational firms seeing their earnings and revenue growth under pressure in Europe.

In my opinion, since March of 2009, all we have witnessing is a rally (a “dead cat’s bounce,” as it is often called) within the confines of a major secular bear market. (See: “These Three Stock Markets Crashing; Is Ours Far Behind?”)

Where the Market Stands; Where it’s Headed:

There’s not much else I can say about the stock market that I haven’t said above. While stocks basically went nowhere during the month of July, investors keep waiting for the Fed to announce the next round of informal money printing. Now we get word it might not happen until September. Is that the only thing supporting stocks…the anticipation of the Federal Reserve pumping the financial system with more money? A scary but true thought.

What He Said:

“Bonds could now be a buy: Bonds rise in price when interest rates fall, as their return makes them more valuable. After a bear market in bonds that has lasted for months, the action in the bond market, as I read it, indicates the bear market in bonds could be over. I’ve always preferred quality when buying bonds, going with government bonds over corporate bonds. If you have some cash lying around, bonds could be a great deal.” Michael Lombardi in Profit Confidential, July 24, 2006. The yield on 10-year U.S. Treasuries fell from five percent in the summer of 2006 to 2.4% in October 2011—providing a spectacular price gain for the bonds Michael recommended.