Sunday, April 28, 2013

Are Small Caps Signaling a Warning for the Stock Market?

As veteran investor and money manager Bob Farrell has noted, the market cannot continue to rally with just a few large-caps (generals) leading the way. Small and mid-caps (the troops) must also be on board to give the rally credibility. A rally that lifts all boats indicates far-reaching strength and increases the chances of further gains.

As seen in the chart below, small caps relative performance vs. large caps peaked in May, 2011.  Since then, performance has lagged, and has taken a pointed hit as recently as March, 2013.  Studies have also noted that small-cap firms tend to outperform large-caps over the years subsequent to an economic trough. In the year prior to the business cycle peak, however, small caps tend to lag. This would appear consistent with the slowing down of economic growth after the sharp run-up of GDP following the 2009 trough. The lagging small-caps may be a warning sign that a peak in the economic cycle is emerging.



Also noted in the chart above, there has been a lag of about 2 years between the peak in small-caps and the peak in the S&P500.  If this relationship holds, it would suggest a stock market peak in the relative near-term.

Taking into consideration the slowing economic momentum and the historic technical relative performance of small-caps vs. large-caps, a potential warning sign emerges for the stock market in general. 

- Baseline Analytics

Saturday, April 13, 2013

Divergences Build as Indices Reach New Highs


Although traders and investors are taught to treat the "trend" as their "friend," we cannot always wholeheartedly trust that friendship as the trend grows older.

As the markets tangle with new highs, several divergences in market index activity have begun to surface, and investors are cautioned to heed their potential warnings.  This is not an indication to give up on the bull trend, but a subtle suggestion to protect capital and to avoid chasing the rally.

Once such divergence has been the performance of financial stocks as measured by the comparison of XLF to the S&P500.  As the S&P500 has reached a new high, the XLF:SPX ratio has lagged in a consolidating pattern.   Financials have been considered to be an important part in confirming a trend.  Their recent divergence is cause for second-guessing the strength of the rally.














Another divergence that has surfaced is the outperformance of value stocks vs. growth stocks.  In "risk-on" environments supporting stock market rallies, growth tends to outperform value.  Similar to the XLF:SPX relationship, growth vs.value has also begun to churn downward:

















Finally, strength in small cap stocks (like growth stocks) are considered indicators of the "risk-on" trade and supportive of market rallies.  Small Caps however peaked most recently in March (lifted from their trough in October) and have corrected rather sharply in the last 3 weeks.  As the chart below also demonstrates, small caps tend to lag the broader market by 18-24 months peak-to-peak.  A similar pattern, if it plays out as it has historically, would suggest rough going for the major indices potentially starting in the next 30-60 day timeframe:














These divergences (and others that have begun to emerge, such as declining peaks in relative strength and the failure of transportation stocks to yet reach a peak as the DOW has), should be considered as a warning for traders and investors to avoid randomly throwing capital at the stock market. This would be an appropriate time to set stops, take a few profits and prepare a buy list for a meaningful pullback.

- Baseline Analytics