Leading Indicator to a Market Top?

An interesting pattern has emerged in the ratio of Small Cap stocks vs. Large Cap stocks.  The Small Cap/Large Cap ratio is comprised of the Dow Jones US Small Cap Index divided by the Dow Jones Large Cap Index.  In March 2006, this ratio of Small Caps vs. Large Caps reached an intermediate term top, as noted below by the black arrow on the far left.  Notice that the ratio peaked 18 months before the S&P500 peaked, in September 2007. 

 

 

Now, fast forward to June 2011.  The Small Cap/Large Cap ratio peaked at that time, as preference for more conservative, dividend-paying large caps exceeded interest in small caps. Today, the ratio sits near support denoted by bottoms in April 2012 and July 2011.  The noteworthy observation in the above chart is that 18 months following the June 2011 peak, is November 2012.

 

Will November 2012 represent a possible intermediate-term top for the S&P500? The S&P500 remains in a clear uptrend, and faces potential resistance near the 1430 area last reached at the aforementioned peak in September 2007.  This is an interesting technical coincidence and is worth watching. 

 

At Baseline Analytics, we are trend-followers and rarely resort to picking targets on the indices.  Our models however assess the risk to the current trend and its probability to change. Although there is growing bullishness as the "risk-on" trade prevails, investors are counseled to remain suspect and protective of their capital.

 

Click here to learn more about how Baseline Analytics TrendFlex can help keep you on the right side of the market.

Revisiting Staples vs. Discretionaries

 

In our August 25th blog, we pointed out that discretionary stocks had take a lead over the more conservative staples. Since that update, discretionaries have surged while staples appear to have fallen off a cliff of relative performance. See the chart below:

Outperformance of discretionary stocks underscore that the "risk-on" trade is "on."  Another confirming indicator included in our chart is the strength in copper prices.  Copper tends to be viewed as an indicator of economic activity, which one would expect to correlate with discretionary stocks.  Note the jump in copper prices (bottom section of the chart) occurred in early 2012 just as discretionary stocks (purple line) took off .  Staples had peaked in December. 

How have these indicators behaved over the longer term?  Below is a weekly chart of the same indicators since 2005.  Note the bounce in copper at the start of 2009 coincided with a surge in discretionaries.  Interestingly, staples meandered in a trading range of relative strength. 

 

 



 

This rather lackluster performance in staples perhaps indicates that such stocks are a parking lot for cash to earn dividends and remain "risk-off" while market uncertainty prevails.  There was certainly quite a surge in staples in October 2007 as the financial crisis continued. But staples underperformed discretionaries since early 2009, suggesting that investors would have been better off watching the relationship between these two indicators, confirmed by an economic measure such as copper prices, to gain better relative returns.