A Divergence For The Decade - Thanks For The Body Check Doc

This morning I was reminded of why I value my friends as highly as I do.  In a discussion on another post with our friend, the ever popular doctor_jr., doc pointed out the following fact: "SPX has been up 9 of the last 10 weeks and the one down week was by less than 2 pts.  European sovereign debt has been the top financial news issue for the entire period."

As would be expected, such a realization struck me as being a rather astonishing and impressive statistic, especially in light of the fact that it actually hadn't dawned on me that that was the case... until doc told me.  But his comment also immediately inspired another thought to come to mind.  And that thought was this: "Really doc?  Since I actually pay more attention to the high risk stocks for faster signals I hadn't even realized that the S&P has been up 9 of the 10 past weeks.  The Russell sure hasn't!".  So I was suddenly shaken out of my stupor by doc's comment and immediately dived into the following analysis, one which I've been totally remiss in failing to investigate for over a year.

There's little doubt that a good percentage of the investing public is aware that in good times, times when there is little fear of a stock market pullback, the higher risk stocks outperform the benchmark S&P 500.  It's a reflection of the attitude toward taking a higher degree of risk without too much fear of suffering losses.  Both the private retail investor community and especially the corporate sector participate in the orgy, more often than not with reckless abandon.  There are so many different methods of measuring the appetite for risk and most of them are very reliable.  In the currency arena, the Aussie:Yen cross has simply been outstanding in its direct correlation with the S&P 500.  Measuring the relationship between the consumer staples stocks and the consumer discretionary stocks is just another in a long list of vehicles that can be used to measure the relative degree of complacency.  The much misunderstood and usually misused VIX is another.  But there probably isn't a more direct measure of the appetite for risk than simply comparing the higher risk Russell 2000 with the S&P itself.  And that's something I admit that I've forgotten to do for quite some time until I was jolted out of slumber by doctor_jr.  For those of you who have never played hockey, I can assure you that there's nothing like a good solid body check to wake a guy up.  And I was always under the impression that doc was a basketball guy!  Go figure!!

In the series of charts below I'd like to draw your attention to the divergences... periods of time when the Russell is either outperforming or under-performing the S&P 500.  It's also very important to be aware of what had been happening in the stock markets in general immediately prior to the development of each of the divergences.  Specifically, were they rising or falling?  The annotations on the charts probably tell the story about as clearly as any more dialogue so I'll simply present the charts in the sequence that I think will display the story with the greatest clarity.  We begin by looking at the weekly chart which compares the price action between the Russell 2000 and the S&P over the past dozen years:

WEEKLY - Russell 2000 compared to S&P 500 over the past 12 years.  These are the only divergences that have occurred in the past 21 years... since the Russell was introduced.  (Right click to open a larger version).  Click here for a live and updated version with a closer look.

The single most important consideration when viewing all these charts is to keep in mind what the S&P 500 (as the benchmark) is doing.  Is it falling during the divergence?  If so, then so is the broader NYSE and there is clearly a lot of fear in
the air.  In that case, when the Russell starts to outperform there are two possible reasons for that to occur.  The investment community is either becoming less and less fearful during an apparent recovery (the markets are bouncing nicely) due to spin by the media... or the market is being manipulated to give that impression.  I have no doubt that it's a combination of those two factors.  But do you know what?  It doesn't matter what the reason is because the bottom line is that the S&P 500 (and the entire broader NYSE) are not participating in the bounce to the same degree as the high risk stocks.  And the end result has always been the same.

On the other hand what does it mean when, during a divergence, the S&P 500 is the one which is rising more robustly?  As seen in the only two divergences when such was the case (designated by the green arrows), the S&P 500 had been in a very solid uptrend for at least the past 3 years.  In the case of 2007, the stock markets were undeniably in a major bull cycle... a cycle that was about to end.  It seemed to be stretching for the stars but the higher risk Russell was having no part of it.  The smart money knew what was going on.  I have to assume that the exact same thing is going on today.  Of course there will be those who choose to declare "this time it's different".  Fair enough.  Those people have every right to draw the conclusion that best suits their wishes and I'll draw the conclusion that makes the most sense.  The markets have never sent a clearer message, they are running out of momentum and are signalling that they want to reverse to the downside.

The reason I wanted to show the weekly chart first was to display how important it is that we are cognizant of what was happening with the broader stock markets immediately prior to a divergence.  With that in mind, we now look at the monthly chart which includes the entire lifespan of the Russell 2000.  Even with this biggest of views, the view from 40,000 feet, we can clearly see that all the explanations I offered above are still applicable.  For clarity, please read the annotations on this chart in the numerical sequence:

MONTHLY - Russell 2000 compared to S&P 500 over the past 21 years.  These are the only divergences that have occurred since the Russell 2000 was introduced.  (Right click to open a larger version).

So the stage is set.  Even on the grandest of scales, the same phenomenon is occurring.  At the top of a bull cycle the Russell 2000 is not only lagging the S&P 500, but has yet again set up a negative divergence.  On every single occasion when this phenomenon occurred the result was the same.  The markets fell... without exception.  And finally, we'll skip the daily chart and go directly to the 60 min. chart below, although I'll provide a link to the daily chart for those who'd care to see it.  

60 Min. - Yet another neg. divergence is in place even on the micro level.  This chart (and a live link to it) are ample to display what's happening on the daily time frame.  But for those who feel they need to see the daily chart, it's available here.

In the chart above we can see that once again, even on a more micro level, another negative divergence is developing where the Russell is not keeping up with the S&P which seems bound and determined to stretch the very limits and attain another local high.  Unless the Russell suddenly surges with explosive force in the coming week, the negative divergence is going to be maintained.  Even if the Russell were to get the Goldman Goose of the Decade award this week, the negative divergence seen in the weekly chart will still exist to such a monumental degree that it would take another 6 months to a full year of incessant liquidity inflows.  The only possible way for that to occur at this stage of the game would be for the FED itself, the ECB and possibly European investors themselves to flee from European investments and throw all the money they can find at the Russell 2000.  And not at the S&P 500.  I suppose that's possible.  But I sure don't think it's likely because if they're in that much fear they sure as hell won't be looking for high risk assets..


And in closing, I'd like to once again acknowledge Doctor_jr.'s huge contribution and inspiration for this study which I had placed on the back burner so long ago that I'd forgotten about it.  Thanks for the body check doc!  This one's for you:

Larry Bird Claps In Applause