Following the Flight to Low Quality

The Russell 2000 has had an incredible run so far this year, moving up 13.6% in the first quarter, while the S&P 500 is up only 3.6%. In fact, the Russell 2000 is at an all-time high while the S&P still has a ways to go before hitting the highs it reached in March 2000.

Part of this is due simply to the laws of physics -- large objects require more energy to move. In other words, a company making $100 billion in annual revenue is less likely to double than a company making $10 million in revenue and just beginning to gain market share.

However, because of this move in the Russell, we are getting the usual pundits claiming that we are seeing a "flight to low quality" and that this usually precedes a crash of some sort.

Let's find out if this is true.

To verify this, I took the Russell 2000 and the S&P 500 indices and mapped the average difference, or spread, between the two indices. I then calculated out when the spread for any given one-month period exceeded the average spread by more than 1.5 standard deviations in either direction. In other words, if the Russell 2000 ran up for a month with the S&P 500 largely flat, then this condition would be triggered. Or, if the Russell 2000 moved down sharply, or more aggressively than the S&P 500 moved down in a one-month period, then the condition would trigger.

If the Russell 2000 moved up too fast, the simulation would short the Russell 2000 ETF (IWM Quote - Cramer on IWM - Stock Picks). If the Russell moved down too fast, the simulation would trigger a long. The trade would exit when the spread would go down to 0.5 standard deviations over the average spread.

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