NIBM - Russell rebalancing a sell signal?

Small cap breakdown and the Russell rebalance

May 24, 2002 David D. Miller, President, NIBM

[Ed. note: This article was originally published in The Internet Financial Connection newsletter appearing at Silicon Investor and e-mailed to over 25,000 individuals. This version includes some minor alterations to better present the information. No material changes were made to the opinions or facts presented. The 2001 version of this article correctly predicted the decline in the Russell 2000. To see the 2001 version, click here.]

My very first column for IFC appeared about eleven months ago and on this very subject. Given the recent popularity of small cap stock funds mirroring the Russell 2000, I thought it prudent to revisit the subject a little earlier this year.

According to the Q1-2002 Morningstar Fund Review, of the $2.9T invested in domestic equity funds, $212.5B was invested in non-index small cap funds. Add to that the $30B the Frank Russell Company claims is indexed directly to the Russell 2000 and that's a significant amount of money. Mutual fund inflow data published by the Federal Reserve Bank of Boston shows small cap funds continue to see the biggest inflows. Consequently, what happens to small caps is important to this market.

The Russell Company rebalances its indices on June 30th each year.

Once per year, the Frank Russell Company rebalances its index. This was not always so. According to the Russell web site, the index was rebalanced quarterly from 1979 to 1986 and semi-annually from 1987 to June 30, 1989.

The increasingly large turnover at rebalancing, combined with growing asset values at small cap funds, has created a rather interesting trading pattern. This pattern has arguably been in place since 1995 and has been especially apparent since 1998. Those who invest in small cap stocks or who own small cap funds should take note of these patterns as they may well help avoid losses or at least assist in the timing of buys.

We've put together a table of the Russell 2000 from 1990 (the first full year with only a single rebalance event) to the present measuring performance from the rebalancing date through the end of the year. While there is no obvious pattern between 1990 and 1994, in 1995 a pattern begins to emerge. That pattern is for the Russell 2000 to peak at some point between the rebalance date at the end of June and a date within a few days of the July options expiration date. In 1995, 1996, and 1997, the index put in second half lows within three or four days of the July expiration, but recovered by the end of the year.

Year	Value at beginning of the year	Value at Rebalancing	Value at July options expiration (date)	July low (date)	Value at end of July	Second-half low	low date	Value at end of the year
1990	168.31	169.12	166.82 (20th)	161.51 (30th)	169.12	118.82	10/31	132.20
1991	132.20	167.61	172.87 (19th)	167.01 (5th)	172.76	167.01	7/05	189.91
1992	189.91	188.64	190.42 (18th)	185.81 (8th)	194.74	185.81	7/08	221.01
1993	221.01	233.35	236.16 (17th)	233.19 (7th)	236.46	233.19	7/07	258.58
1994	258.58	240.29	245.62 (16th)	240.68 (6th)	244.06	235.16	12/09	250.36
1995	250.36	283.63	290.52 (21st)	283.74 (3rd)	299.72	283.74	7/03	315.97
1996	315.97	346.61	321.54 (19th)	307.77 (24th)	316.00	307.77	7/24	362.61
1997	362.61	396.37	405.89 (18th)	394.13 (1st)	414.48	394.13	7/01	437.02
1998	437.02	457.39	462.36 (17th)	419.75 (31st)	419.75	310.27	10/08	421.96
1999	421.96	457.68	465.26 (16th)	441.58 (29th)	444.77	408.90	10/18	504.75
2000	504.75	517.23	522.70 (21st)	490.22 (28th)	500.64	443.80	12/20	483.50
2001	483.50	512.64	487.93 (20th)	474.26 (24th)	484.78	440.73*	9/10	488.50
2002	488.50	512.64	n/a (19th)	n/a	n/a	n/a	n/a	n/a

* We chose the pre-9/11 low for a better representation. The actual low was 378.89 on 9/21.

In 1998, 1999, 2000 however, this pattern became more defined. In each of those years, the Russell 2000 climbed from the rebalance date through the July option expiration and then plummeted from there through the end of July. That downward trend continued to significantly lower levels later in the year. In 2001, the pattern altered itself somewhat: Gains in the Russell 2000 didn't make it as far as the July options expiration. They went into a free fall immediately after the rebalance, losing 7.74% in the first seven trading days of July.

Year	Rebalance Close	July Peak (date)	Gain	July End	Decline from Peak
1998	457.39	463.64 (16th)	+1.37%	419.75	-9.47%
1999	457.68	465.80 (15th)	+1.77%	444.77	-4.51%
2000	517.23	545.17 (17th)	+5.40%	500.64	-8.17%
2001	512.64	508.59 (2nd)	-0.86%	484.78	-5.81%

In every instance beginning in 1998, not only was the July-end number significantly lower than the July peak, it was also lower than the value of the Russell 2000 at its rebalancing. In those four years, the earliest the Russell 2000 regained the level it had at the rebalancing date was December. While the events of 9/11 are certainly a mitigating factor, I would note the Russell 2000 still has not returned to its 2001 rebalance levels.

Recent declines and increased price volatility in the Russell 2000 - and our home turf, biotechnology - could be explained by funds gaming changes to the index. The weakness in biotech and strength in consumer goods, energy, and industrial sectors could mean a net outflow from biotech.

Because the index is calculated on straight market cap, gaming the winners and losers is not much more complicated than importing tickers and market cap data into an Excel spreadsheet and hitting the "sort" button. Shorting the departing companies and going long the arriving companies has been a relatively easy way to make money. This strategy is well known for S&P-500 additions and subtractions and most of the major investment banks will release research on this strategy to retail clients in two or three weeks. Movements between the large-cap Russell 1000 and small-cap Russell 2000 also offer opportunity for profit, though this strategy is slightly more complicated.

On June 7, the Frank Russell Company will release a list of the likely additions and deletions to their small cap indices. They will update this list twice during June. The index is set as of the closing price on June 28^th (the last trading day) and the final list will be made public at 5pm PDT on July 9.

In 2001, 607 companies were added to the Russell 2000 and 429 were dropped. This was the biggest ever shift and it made for a very volatile small cap market beginning in mid-June 2001.

Small cap investors would do well to keep this information in the back of their minds as they watch small cap stocks gyrate in the coming month. Those inclined to invest in a Russell 2000 index fund in the next few weeks would do well to rethink that strategy given the four-year pattern of a June/July peak in that index.

Remembering the letters I received the last time we ran a similar column, let me say the following: I am perfectly aware historical analyses of the stock market are limited. I am even more aware the fact we are (at worst) in a bear market and (at best) in a transition to a bull market may render historical comparisons to 1998-2001 essentially meaningless. The statisticians among our readership will no doubt tell me five years is an insignificant sample compared to the entire history of the Russell 2000 price action.

In response, five years is an eternity in the stock market as trends go, convincing me there is more than coincidence behind this pattern. I would also argue the rise of index funds and the use of index derivatives makes comparisons outside of the last decade essentially meaningless for forward looking purposes. Given that, a distinguishable pattern in five of ten years is statistically much more persuasive. Finally, this market makes it hard enough to make money so it would be foolhardy to ignore such an established pattern.

Let the e-mails begin!