The Russell reconstitution produced a volume surge even higher than the quadruple witching the prior Friday. The quadruple witching expiration spiked the volume to 9.265 billion shares the prior Friday. The Russell reconstitution sent volume soaring to 10.884 billion shares this Friday. That is a massive amount of volume since the average is about 6.0 billion on a normal weekday.

The Russell reconstitution occurs once a year on the last Friday in June. Russell ranks all the stocks in the market by market cap and removes non US stocks and several other classes of securities. What they end up with is a list of all tradable stocks by market cap. The top 1,000 by market cap become the Russell 1000 index. The remainder of those 3,000 stocks become the Russell 2,000. For example, on any given year there could be 100 stocks that have risen in market cap to move from the Russell 2000 index into the Russell 1000 index. That pushes the 100 smallest stocks in the Russell 1000 back into the Russell 2000. Every year there are new stocks that have made the grade and are now eligible to be added to the Russell 2000. That means an equal number of stocks are going to be eliminated from the index.

Russell publishes the expected additions and deletions around the 1st of June. They revise that list about 10 days before month end. Hedge funds try to game the system by buying the additions in advance and shorting the deletions. On reconstitution Friday they try to unload those positions for a profit in the high volume as thousands of portfolio managers are forced to buy and sell.

Because market caps change throughout the year every stock that is currently in the indexes sees their weighting change. This forces portfolio managers tracking the indexes to buy or sell EVERY stock in the Russell 3000 universe. It may be only a few hundred shares each or a few thousand. It depends on how much the individual market caps have changed and their new weighting inside the indexes.

The entire process on Friday runs so smoothly that it rarely impacts the market despite the heavy volume. On Monday, portfolio managers will review their portfolios compared to the Russell rankings and further adjust their holdings. Since the entire process is computerized, there will still be some adjustments but only minor in volume. Where trouble could appear is the leftover stock from the hedge funds trying to game the system. If they were unsuccessful in selling for the price they wanted on Friday, they will be looking to liquidate those remaining holdings on Monday. This can cause some downward pressure at the close as they hit the exit button on any remaining shares.

This reconstitution process messes with the normal technical indicators because thousands of stocks are being bought and sold based on a math program rather than any fundamental or technical reason.

In a rising market like we have had in 2019, market caps for most stocks have risen and therefore more buying is needed to bring the funds tracking the indexes back into balance. This powered the A/D ratios to new highs on the S&P, but this is a false indicator this week because of the forced buying.

The small cap Russell 2000 was a prime beneficiary of the rebalance and surged 1.3% on Friday for obvious reasons. Since this was forced buying and not based on fundamentals, we could see the prior weakness return by Friday.

The small cap A/D line is not at a new high despite the buying surge. Small caps are still struggling.

The Russell has major resistance at 1,585 and 1,600. It would take a major change in market sentiment to power through those levels. However, with the Fed expected to cut rates in July and the China trade confrontation delayed for another 90-days we could see some new buying interest. On the flip side, the summer doldrums are normally unkind to small cap stocks.

The trade truce and the reversal on sales to Huawei should lift the chip stocks and that should also lift the Nasdaq. Chips were up last week in advance of the G20 on hopes for a breakthrough.

Google reversed course last week and moved lower creating a drag on the tech index. The other FANG stocks moved sideways ahead of the G20 because of the additional uncertainty and profit taking from the prior gains.

The Dow chart did not change from last week. There are still two levels of strong resistance and even with the +220 spike in the futures, those levels will still be in play. The prior high was 26,828 and that is the level to watch.

After the reconstitution of the Russell 3000 this will be the index to watch this week. The prior record high at 1,738 is the critical level and a move over that level could trigger some significant price chasing.

The VIX plunged at the close on Friday as the result of 3,000 stocks being bought in the reconstitution. With the S&P futures up +29 on Sunday evening it will likely fall again on Monday.

As I said in the market commentary, I would not be a buyer at the open on Monday. We do not know how long this short squeeze will last and once the details of the Trump/Xi meeting begin to leak out, the market could lose traction rapidly. Be patient, we will probably revisit these levels again soon.

Enter passively and exit aggressively!

Jim Brown

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