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:
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S&P100 ratio to S&P600
Source: Ritholtz Research & Analytics
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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.
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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 . . .
I pay attention to the relationship and the persistency of trends — thats what interests me most —
As long as ratio was in the down channel, I was happy to avoid big caps and stick with smaller names. Now I am rotating away from small caps.
How is that hind site?
Big-Cap Time – Finally?
Barrys right says over at The Big Picture, weve heard them tell us over and over, year after year, that THIS was going to the be year of the big cap stocks:
For example, for the past 5 years, we have heard pundits wishfully say this was …
there is a case for select small cap names that have restructured with lower debt costs and are set to grow…and to pair that with a russel index short….I’m a sucker for a few smaller companies, however, I respect the chart shown.
Barry,
This article from Hussmand funds talks about the
same thing:
http://www.hussman.net/rsi/relativevalue.htm
Better relative performance for big caps does not mean positive returns in the near future
I set up a dollar neutral trade by being long DIA and short IWM three months ago. I’ve made 10% on my long market value.
The technicals are signalling a set-up now?
excellent point nskca. the trap of relative performance can be a painful one in a bear market. hey everyone, my large cap growth fund only went down 25% while the rest of the market was cut in half! woooo hoooo!
IF TA is hindsight then what are fundamentals? And how do you pick stocks? Enlighten us.
A long term chart of the small cap indexes shows a bubble that is very similar to the Nasdaq bubble the burst in 2000. Some things never change. What goes up too high too long eventually quits going up.
The fact is that market leadership rarely transitions during a bull market – but rather in bear markets. The most recent cyclical bear from 2000-2002 was a perfect example, as small cap (particularly value) and emerging markets significantly outperformed on the downside…though not producing great absolute returns. I would expect the Russell 2000 to go down 1.5-2 times as much as the S&P 100 during this bear market – just as the May 10th – June 13th decline showed.
For those that are really bearish, check out UCPIX
I actually tried to put on this exact trade last week…short the 600/ long the 100, and couldn’t get filled on the IJR short (none available to borrow at my broker).
These are one of the few “macro” type trades I’ll take because of the hedged nature of the trade. Macro calls can go horribly wrong (Niederhoffer anyone?) but big cyclical trend changes, traded with a hedged instrument is about as simple as it gets.
And while fundamentals are nice to have on your side, it’s a market of stocks not a market of companies (unless you have billions of PE at your disposal and then I suppose it really is a market of companies).
I’d be a little careful about arguing rotation rather than mean reversion. Trying to confirm the graphics I ran RUT vs $OEX from 88 to now and found that thru ’98 they were conincident, i.e. no divergence but the large caps were the bubble and the post ’03 small-cap runup was just restoring valuation balances. Which got excessive – it was an exploitable anomoly for those brilliant enuff, unlike myself, but appears to be being priced out. BtW – a similar analysis comparing $SML to RUT from ’95 to now shows that $SML & RUT move together. The update chart is a little hard to read but….it might be worth validating some more before we all take it to the bank.
Pete,
IJR is very low volume. Did you consider using IWM as a proxy? Much higher volume and the chart patterns are almost identical.
Alternatively, if you’re into options: IJR puts and OEF calls.
Woah. Speaking of rotation, how about from bonds to stocks and back as another proxy for risk aversion? I was digging through the fantastic slides posted earlier by joe from the Boston Fed and found:
http://www.bos.frb.org/economic/mmfr/mmfr2006/aug2006.pdf
Figure 7 has my eyeballs rolling across the floor. Look at the volatility in equity fund flows that began in 1995. Inflation probably exaggerates the increase, but I actually find these graphs a little comforting. This helps me reconcile how silly and surreal the tape has looked for some time with some empirical evidence.
We’re currently experiencing a sharp spike down in inflows to both equity and mixed/bond funds. It looks to me like ’95 also happens to be the last time we had a sustained dip in both equity and bond fund inflows. Most of the others look like knee-jerk rotations in one direction or the other, with a spectacular ’00 spike. That last double drop coincided with the next leg of our amazing bull market, depicted in figure 8.
What does it portend this time?
Yeah Craig, I did look at using the 2K as a sub, but ended up with my limit positions put on in other trades and just dropped it. I use a max risk per position, per correlated markets/instruments, and per direction. I was loaded on a per direction basis. (And every damn one of those trades except one is going against me right now, lol!)