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The Great Rotation into the Russell 2000

Last week the Great Rotation began, that's where bond investors begin to transition into stocks, and usually that means high dividend paying stocks have unusual buying activity, but something else is happening that may be counterintuitive to the otherwise conservative nature of the rotation.

Usually, bond investors are conservative, but that may not be the case for many recent bond fund investors.  Instead, they may have invested in bond funds to chase performance, and after seeing the stability and total return most bond funds experienced between 2008 and 2012, who could blame them. 

However, now that those bond funds have turned, and net losses exist with over $120 Billion of net worth being wiped out of long term Treasury Bonds alone (this does not include other bonds), those investor who were chasing performance in bond funds a year ago, may now be chasing performance in the Russell 2000, and therefore logically the iShares Russell 2000 Index (ETF) (NYSEARCA:IWM) which is largely  comprised of smaller cap stocks.

Almost quietly the Russell has been breaking out, it started to do this last week, and it is now at all time highs.  Chart patterns show no clear resistance levels in front of the Russell, and money flows into small cap stocks seem more consistent now than ever before.  The catch is that the Russell 2000 has a P/E multiple of over 59x earnings, but investors who chase performance do not care about that.

Not unlike what they did when they chased bond fund performance, investors who are unwittingly swapping bond funds for the Russell 2000 are setting themselves up for an eventual fall.  Some will argue that earnings are expected to be great for small cap stocks, and that might be true, but even if Russell EPS growth was 25% the multiples would still be excessive. 

Investors who chase performance do not care about this sort of thing, but those are also usually the ones we define as the masses too.  The old adage on Wall Street is that we should not follow the herd, but that only applies when momentum is not a factor.  During momentum moves the best thing to do is to run with the pack, but you also must be nimble enough to get off the ride because when the music stops reversals happen fast.

Stock Traders Daily has issued recommendations based on the Great Rotation that suggest exactly this.  As bond market investors rotate into stocks the equity markets are likely to experience unwarranted buying pressure, that will tame the pessimism on the Street, and with a lack of selling pressure multiple expansion is very possible in the near term.  Then, that will be followed by an immediate period of multiple contraction, where the PowerShares QQQ Trust, Series 1 (ETF) (NASDAQ:QQQ), SPDR S&P 500 ETF Trust (NYSEARCA:SPY), SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) , and Russell 2000 will all fall back to historically acceptable P/E multiples.

Triggers may have already come
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Red= Resistance
Green = Support

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