Friday, January 04, 2008

US Small Caps are in a Bear Market

Let me start by saying that my titled opinion is based entirely on the chart of the Russell 2000 index seen above. This is a pretty reliable measure of how growth stocks are doing, and growth is important because thats what leads the broad market. According to investopedia the Russell 2000 is:

"An index measuring the performance of the 2,000 smallest companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. ... The weighted average market capitalization for companies in the Russell 2000 is about US$1 billion and the index itself is considered to be the benchmark for all small cap mutual funds."

Its a big deal and in late 2002 the small caps were the first stocks to begin climbing out of the nasty bear market early in this mellinium (2000-2002). They led the way to a recovery which turned into a powerful 5 year bull market, one that officially ended today.

I don't want to make a big long post about it, just look at the chart above. After forming what looks like a perfect double top, the Russell 2000 closed today below its major area of support around 735. There are now a series of lower highs and lower lows in place, the 50 day moving average is below the 200 day and they are both declining. By any measure the small caps are in a serious downtrend that could last for years.

What is a bear market and how bad can it get? Google has many definitions. I particularly liked:

"A falling market in which bears would prosper."
"A market in which the primary trend is down."
"A prolonged decline of stock prices usually occurring over a period of months or years. May also describe a general belief by many investors ('bears') that prices are in a falling pattern."

but the standard definition is

"Any market in which stock prices are declining for a prolonged period, usually falling by 20% or more."

At any rate, I continue to expect significant declines in the broad market from these levels based on the charts. In the 2000 to late 2002 bear market the Russell 2000 index fell almost 50% from peak to trough while the index has only fallen 15% from its all time high set in July 2007. Using the top pattern formed by the Russell 2000 you get a target of about 620 which is 14% lower and would be a 28% decline from the all time high. I suspect we will get there in a hurry then the decline will slow down and eventually we will go flat for a while.

In my view, we are clearly in an environment where owning any stocks is a bad idea. If you know a company well or there is some counter trending sector then all the power too you but the majority of stocks will decline in value, in my humble opinion. One thing I caution against is convincing yourself that big caps are ok because they have dividends and are more stable. I would certainly expect them to fall less than say tech stocks but not less than their dividend yield. Yeah the yield goes up when they fall but if the stock declines 10% then you just lost a net 4% on your 6% div yield stock. There are safe ways to return a decent yield without any risk to loss of value in the underlying.

Now I know ya'll aren't surprised by this one bit, in fact you called the top in August when 44% of you voted that the bull market was over. Congratulations! Also, it has been known for some time that the homebuilding sector, financial sector, and retail sector were already in bear markets. But now we have a major index officially in "down mode" so for those of you who want to do better than the 4-5% safe returns on savings ("cash") its time to start acting like bears. There are plenty of stocks with major downside ahead out there and I plan to find them. If you want a less aggressive way to play it just buy one of the ProShares Short ETFs like RWM or PSQ, they will increase in value as the market drops and fore all intensive purposes they are just like stocks.

Just remember, you are fully responsible for you own investment decisions. The fact that I see the stock market falling doesn't mean that it will actually happen. I'm not trying to give investment advice here, just stating some things that are on my mind in hopes of sparking some thought and dialog with the readers. Any thoughts?

Here's the most recent video from our friend Don Harold:

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