Technical Analysis gets a bad name, and for all the wrong reasons. People seem to be put off by some of the more esoteric pattern recognition issues, and that’s a shame.
I prefer my technicals simple: A good chart is worth more than 1000 words, and can provide greater clarity and conviction than most fundamental stories.
For example, for the past 5 years, we have heard pundits wishfully say this was the year of the Big Cap stock. 12 months later: they said, "No, I meant THIS year;" and after another year, we heard, "No THIS year!
Why bother guessing? If you track the ratio of Big Caps (S&P100) to Small Caps (S&P600) you can see a clear trend in their long-term relationship. When that ratio is trending lower, the small caps are outperforming the big caps. When its trending higher, the big caps are doing well.
The chart below is a perfect example: Its apparent that, after 3 years, the downtrend ("Channel") of this relationship has been in has been broken, as has the 50 week moving average:
S&P100 ratio to S&P600
Source: Ritholtz Research & Analytics
Now, we can discuss all the fundamental reasons for this: We are late in the business cycle, small caps
tend to get the extra mileage out of low cost borrowing, which is now much higher; I’ve seen arguments that claim the smalls are much more sensitive to rising commodity prices, where as big caps can extract volume discounts. Also, once the Fed
stops, the dollar has historically tended to get weaker – that works to the
benefit of bigger cap companies with more extensive overseas exposure.
All these stories may or may not be true — but the bottom line is that if you own a lot of small caps and no big caps, the odds favor you underperforming over the near to intermediate term future.
UPDATE August 14, 2006 2:35pm
Rob Fraim sends along this chart via Art Huprich, Technical Analyst at Raymond James
The concept is quite similar . . .