Tuesday, January 19, 2016

Stock Market Trend and Russell 2000

We have been discussing market and its down trend for quite some time at Understand, Survive and Thrive. It seems like this relentless downtrend doesn't want to end any time soon. Oil keeps on falling and keeps dragging the stock market with it. At some point market will rally but in a downtrend one cannot trust the rallies. In fact, hoping for a rally in a bear market is akin to hoping for a correction in a bull market.

Rallies will come but will be short and sweet. By the time people embrace them, they will be over and the primary trend will resume. One of the biggest red flag in current market is the significant under performance of Russell 2000. Russell 2000 is a small caps index and small caps are most impacted by changes in economic conditions because they are most sensitive to credit availability.

These business depend on economic growth and easy credit for their survival. Therefore, whenever you see small caps declining, its a major red flag.

In December, we highlighted that Russell 2000 ($IWM) was forming a head and shoulders topping pattern (link). The pattern looked like:

Now a completed pattern looks like following. This pattern still has another 7% decline left before it reaches its measured target level.

Small caps are already in official bear market, another 7% decline will bring the Russell 2K index in low 900s.

This analysis shows the importance of objectivity in investing and why trend following is critical. An up-trending market will find excuses to go up and a down-trending market will find fundamental and technical excuses to go down.

At this time, long-term trend in stocks is down. So every rally attempt should be treated with caution. Downtrends implication are very severe on the economy. We might be headed for a recession. Junk bonds and oil related bonds are doing poorly. This could be another area of serious concern. We will continue to evaluate the situation. But the bottom line is the best portfolio right now will be a portfolio who beta is lower than the SP500. Lower beta would reduce your risk in a down market and will allow you to preserve capital.

In the next few blog posts, I will share our portfolio which is a -0.56 beta and is beating the market since the start of the year.

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