I analyze macroeconomic issues from a fundamental perspective, and I analyze market behavior from a technical perspective. Original macroeconomic analysis can be found here and both macro analysis and commentary can be found on my Caps blog. If you like or appreciate my analysis, please add yourself to my Following List

Sunday, October 30, 2011

Long Term Thoughts on the RUT

Okay, it's time for Crazy Uncle binve's Unpopular Opinion and EW Count Time!

Today's installment will be regarding the Russell 2000.

First, let me say that this has been a point of particular focus of Blankfiend, such as this post and several others. I really appreciate his efforts because the RUT does not display the same characteristics as the other indices.

Second, let me say that I am expecting little to no agreement with this post. In fact, I am expecting to get a lot of disagreement / 'what are you smoking' type comments like those that I got with this post.

Third, I think most of the standard macroeconomic analysis that accompanies long term projections is partially if not completely flawed. I think only a tiny minority of analysts actually understand monetary systems. I think only a tiny minority understand that the US and the EMU operate under fundamentally different monetary systems. I think only a tiny minority understand what a sovereign debt crisis really is and the fact the the US has no sovereign debt crisis whatsoever (except for a self-imposed 'debt' ceiling constraint). There are no US Government Bond Market 'Vigilantes'. The US is not on the doorstep of a hyperinflationary depression.

I think I see things a bit differently than most TA and EWP analysts out there.

I view long term trends through the lens of macroeconomic policy decisions. And currently, while the US is cutting back spending, it is not embracing full-blown austerity. This means that current deficits of ~9% of GDP are supporting aggregate demand in the economy, and stocks can still generate reasonable profits and profit growth in this environment. Not stellar, but enough to limp along. Remember, the stock market is not the economy.

But there are major long term risks. NOT US sovereign debt (which is not a bubble, despite those trying to call the top in it). But the size of the financial sector and the continued financialization of the US economy. I think the financial sector, and the instability it promotes, is the biggest impediment to long term growth. And we saw from the 2008 crisis that the financial system was not reformed (even though we had our chance). TBTF was allowed to become TBiggerTF. See section 5 of this post.

My point is that the US can continue to limp along so long as austerity is not embraced (Of course, like I said here and here, if the US significantly embraces austerity, then all bets are off and look out below.). But that the instability that the Financial Sector creates will precipitate another cyclical bear market.

That in a nutshell is my macro stance:

1. We are in a secular bear market, because the cancer (size of the Financial sector) was never removed from the economy
2. The instability that the Financial Sector creates will precipitate another cyclical bear market
3. The next cyclical bear market will cause enough animosity that there will be political will to finally reform the financial sector
4. At the end of the next cyclical bear will be the end of the secular bear market (that started in 2000), and the next secular bull will begin
5. As long as the US does not fully embrace austerity, then a Great Depression-type scenario can be avoided. If it does embrace austerity, then all bets are off and look out below (and God help the US economy and population).

My long term thoughts that go along with these macroeconomic conditions are described in a few posts:

-- Update on Long Term Projection
-- Secular Bear Market Projection in Historical Context
-- Lessons (To Be) Learned... again.
-- Real Secular Bear Markets

Also, there is a lot of good background reading in this post: First Derivative of the S&P 500, Long Term Study and My macro tab.

So how the the RUT fit into all of this?

I think calling the RUT a major broad market index is misleading. I think the RUT is to the SPX as what JNK is to LQD (roughly speaking, I am *not* suggesting that all RUT stocks are 'junk' stocks). They each measure different things. But I think the SPX is a closer representation of the the expectations of what is happening in corporate America and the US economy than the RUT is. I think the RUT is a measure of smaller and much more speculative issues.

As such the RUTs gains and losses are much more exaggerated. And as the financialization of the economy continues and leveraged money continues to look for gains, it will find its way into riskier assets. And yes, I think the RUT is a much riskier asset class than the SPX. And so I think that this 'overshoot' phenomena to the upside on the cyclical bulls (and much higher than then end of the last secular bull) can be explained by this observation.

With that, here are my thoughts on the monthly chart of RUT:

I am calling the end of the secular bull in the RUT a bit earlier (1998) than then end of the secular bull in the SPX (2000). And what we can see is that the 'middle wave overshoot' phenomena occurs relatively early on in this large corrective period.

I think one of the keys to recognizing this is the fact that the move from 2002-2007 is clearly not an impulse. However you want to subdivide it, it looks and counts like a corrective wave up that goes to clearly new highs. Yet it is not an impulse (and hence cannot be the start of the new secular bull market).

The upshot is that I think the RUT, like the SPX, is in the middle of its secular bear market. And if I am correctly identifying the end of the previous secular bull (500 in 1998) then the next cyclical bear (and likely the end of the secular bear as well, subject to the macro caveats above) will make one more move below this level.
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