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Is it time to buy small caps?

The World Bank expects the developing East Asia and Pacific region to grow 6.9% in 2014 and 2015, down from the 7.1% rate it had previously forecast for both years. Growth in 2013 had been 7.2%. The bank also trimmed its 2016 growth forecast for the region to 6.8% from 7.1%. Last week, the IMF also warned of slowing growth globally. With Europe and Japan struggling and the Fed ready to raise rates, the outlook for slower growth seems certain. So there is a trade setting up, but could it be value trap?

The large-cap US indices are dramatically outperforming the small-cap indices and this has been a developing trend all year. The total return of the S&P 500 is about 7.5% while the total return of the Russell 2000 is approximately -4%, an 11.5% gap. So trend indicators are extremely cautious as small cap stocks tend to be far more economically sensitive. The dramatic under performance started between March and May and it did not seem to coincide with a notable turn in any economic statistics, but we do note that this is when the IMF and others started downgrading the global growth outlook. Other credit risk metrics started to decay shortly thereafter. The Russell held 52-week lows this week so a close below 107 for the IWM would be a negative sign in the coming weeks.

One of our favorite short-term breadth indicators is the McClellan Oscillator and the summation index. The second chart in the video highlights the Russell 3000 index, one of the broadest measures of US large, mid, and small cap equities and the summation index. Breadth readings of -300 or more often indicate major tradable bottoms, though in recent history, readings of less than -200 have market short-term trading lows. McClellan currently suggests that one more new low is possible, but that we have likely seen the seasonal bottom. Whether there is one more new low or not, the message is that we should be buying dips seasonally. The question is whether seasonal influences will be strong this year given the end of QE and Fed rate hikes on tape for 2015. The percent of stocks in the Russell 3000 (3031) at least 10% below 52-week highs is now 2109 (69.6%) while 185 (37%) of 502 stocks currently in the S&P 500 are below 52 week highs. Compared to last month, there has been a notable decay. In Canada, 157 (62.5%) of 251 stocks in the TSX composite index are 10% or more below 52 week highs. What is going on under the hood is not being fully reflected in the averages, but typically is warning of more weakness to come.

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