Over the last couple of months many market commentators have highlighted a notable divergence developing between the major indexes. Typically, such divergences—where the averages are moving in opposite directions over a prolonged period—are either positive or negative, and signal potential major shifts that are about to take place for the stock market as a whole.
In this case, the Russell 2000, which is heavily weighted towards small cap stocks, and the NASDAQ, which is heavily weighted towards growth and technology stocks, have been declining from their highs set earlier this year, while larger cap stocks comprising the S&P 500 and the Dow have been holding steady or hitting new highs.
Since growth areas of the market usually lead the stock market higher, this potential negative divergence was one reason why some market commentators believed that it would resolve to the downside and either lead to a correction or even mark the beginning of a major market top.
Is there a positive reason for this divergence that investors may be overlooking?
In a recent interview with Financial Sense Newshour, David Nicoski, Director of Research at Vermilion, said that the selloff in U.S. small cap and technology stocks is due to investors rotating into Europe and international equities as the global economy recovers.
Nicoski: “What we believe is happening here at Vermilion is, and I think there's very few people out with this thought process, is that the rest of the world is recoupling with us. And with that is going to come some trials and tribulations in terms of the high growth areas that were certainly extended and egregiously priced and I think that this right now is…a hiccup rather than a true start of a bear market. Bear markets usually occur when you get a sector that breaks below that 200-day moving average and, thus far, you are relegated to no real major breakdowns in terms of a sector orientation and I would say that is pretty much unheard of in my experience that you would start a bear market without breaking 200-day moving averages in a sector.”
“I think here in the U.S. we don't know what a recoupling looks like since it’s been years and decades since we've had to go through one. If you look back over the last 5 years, most people said that the U.S. markets could not decouple from the rest of the world—in fact, we did. Now we're having a recoupling and, again, I don't hear anyone talking about it.”
So what are the most recent leading economic indicators (LEIs) saying for major countries around the globe? Matthew Kerkhoff at Dow Theory Letters recently posted the following table showing how nearly all of our major trading partners are showing positive trends in their LEIs with the exception of Brazil and Mexico (see far right column).
Whether this is indeed the beginning of a global recoupling or a short-term trend, only time will tell. For now, LEI data is clearly more positive than six months ago.
Given Vermilion's belief that this trend will continue, Nicoski tells listeners to look at small to mid-cap names with exposure to Europe and Asia.
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