Where the Weaknesses Lie: Small Caps and Junk
Larry is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
We’ve enjoyed a market rally since October, culminating in a very strong first quarter, the best since 1998. Still, there are a couple of popular asset classes that show signs of weakness: small capitalization stocks and junk bonds.
I suspect that the rally likely will last a while, but that the first quarter will prove to be 2012’s best. The broader picture is that we remain in a secular bear market, which has lasted for 12 years. Secular bear markets are long-term trends, and can be punctuated by rallies, like the one we’re in now.
On average, secular bull or bear markets run between 18 to 20 years. So ordinarily we can expect another six to eight years of downturns ahead. This secular bear started with the tech bust and continued with the 2008 financial crisis. Last year, except for the pick-up in the fall, featured a nasty slump and ended up flat overall.
This year, despite Wednesday’s sell-off, Nasdaq has gained an amazing 20.9% and is in a parabolic uptrend. Nasdaq is a weighted index, meaning it is a weighted average of the returns of each security in the index, where the weights are proportional to the value of the listed company. No surprise that Apple (NASDAQ: AAPL) makes up about 17% of the Nasdaq and is now the most valuable company in the United States. But even Apple has to beware of gravity. Apples have been known to fall in the past.
Looking ahead, we have the seasonal weakness of the summer months and likely a nasty general election raging until November. This upcoming market environment is about as conducive to creating great rallies as arctic water is to generating hurricanes.
We can see stock prices are still rising. We also see a divergence between prices, which continue to climb (higher highs), and the underlying technical indicators such as relative strength (the performance of individual stocks versus the broader market) that trend below their recent high water marks (lower highs). While the rally remains intact, its underlying foundation is beginning to weaken. Markets are forward-looking so this suggests we may be seeing the early warning signs of a pullback.
There is a decaying of some technical indicators that become the proverbial canary in a coalmine. Early coalmines did not have sophisticated ventilation systems so miners would carry canaries inside cages down into the coalmines. Canaries are sensitive to methane and carbon monoxide. If the canaries stopped singing, the miners knew their air was noxious and evacuated.
In the markets, the canary is the small-cap index. Small stocks are the first to suffer as a market slumps. Since the market's low last fall, the small-cap indexes surged ahead of the Standard & Poor’s 500 (large caps) and Nasdaq (heavy on tech stocks). But lately their advances are blunted, which we technical analysts call resistance. Look at a well-known exchange-traded fund that tracks the chief small-cap index: The iShares Russell 2000 (NYSEMKT: IWM) is up 28.9% since the October low, but last week lost 1.1% while the S&P gained. If you hold this ETF, consider lightening your position. Otherwise, avoid it.
The same goes for ETFs focused on junk bonds. The SPDR Barclays Capital High Yield Bond (NYSEMKT: HYG) has outpaced the fixed-income benchmark, the Barclays Capital Aggregate Bond Index, which covers U.S. investment grade issues. Last week, the junk ETF was down 1.3% and the Barclays AGG lost just 0.3%.
If we see a turnaround, and the canary starts to sing again, we will increase our invested position in junk. If not, we will exit our positions. After all, asphyxiated canaries and market consolidations can occur very quickly.
George Clausen is president of Clausen Capital Management in Charlotte, N.C.
Motley Fool newsletter services recommend Apple. The Motley Fool owns shares of Apple. This post was written by George Clause and edited by Larry Light, editor-in-chief of AdviceIQ. Neither owns shares of any of the companies mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.