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How Small Caps Are Outperforming The Wider Market at Trader’s Narrative

The majority of traders’ attention is focused on popular indexes like the Dow Jones and S&P 500 and their large cap components. But as Lowry Research alluded to in the recent update, small caps have the upper hand right now.

While everyone is watching the S&P 500 index struggle to regain its January 2010 highs of 1150.45 the small cap index is now well above its previous high. Given, the most popular large cap index is just 1% away from its January top but the S&P 600 index is now +2.58% above its January high. And the mid cap index (S&P 400 index) is, as you would expect, somewhere in the middle: +1.9% above its January high.

So there is a clear stratification of relative strength within the market right now. This is why it is critical to not just look at the headlines or the major indexes but to peel away the layers to really understand what it going on inside the market. Here’s a short term chart of the S&P 600 index showing the decisive break out to the upside:

S&P 400 index small cap Mar 2010

That red/green line drawn at 340 was acting as resistance at the January highs but it is now decisively broken to the upside. Since it is rather an important level, let’s zoom out a bit more to show you just how critical it is:

S&P 600 index small cap Mar 2010

As you can see, this was the support line that the market bounced off several times in 2008 just before breaking lower and causing the cascade of panic selling in late 2008.

This is only a small glimmer of the much larger trend deep inside the stock market. To show you that, let’s zoom out even more to get a very long term perspective of the dynamic between small caps and large caps. Here’s a chart of the equal weighted S&P 500 index divided by the standard, market capitalization weighted S&P 500 index:

ratio equal weight to standard S&P500 index long term chart Mar 2010

As of today’s close, the equal weight S&P 500 index is 1.6% higher that its January highs. Now, technically, I used the Rydex S&P 500 Equal Weight ETF (RSP) and the S&P 500 Index ETF (SPY) to create that chart but the distinction is moot as both ETFs are based on the respective S&P 500 indexes.

Anyway, the important thing is that small caps and large caps take turns outperforming each other. There is also an interesting symmetry in how they do this. For the 6 years from 1994 to 2000, the large caps had the upper hand. Then at the pinnacle of the dot com bubble, the small caps took over for the next 6 years.

From 2006 until the market bottom at 2009, once again, it was the large caps that had a better relative strength. Then at from the market bottom until now, the rally has belonged to the smaller capitalization stocks. In fact, the S&P 400 index has rallied +95% from its March 2009 low. In comparison, large caps have gained +71% to today’s close and +72.5% if we take the January 2010 high.

This relationship isn’t a straight line of course, but when we step back and get a very long term perspective, the trend becomes clear. The market can always throw curve balls like what happened in 2002. Setting aside such short term setbacks, this trend tends to persist for at least a few years at a time.

Since the most recent trend started just a year ago, I think that the current small cap out performance will be with us for a while yet. If the symmetry thesis is borne out, then this could last for another 20 months or so. So if you’re not looking at the small cap sector, you’re missing out on a lot of high beta, high relative strength stocks.

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One Response to “How Small Caps Are Outperforming The Wider Market”  

  1. 1 j

    This is interesting. Thanks for this. I just happened to be looking at small caps Vs large caps a couple days ago and came to the conclusion of SCs have just totally smoked LCs for the last ten years. I was previously unaware of this and do mostly follow the biggies. I used RSP/SPX for my calculations.
    After reading this post of yours I have again went back and researched back to around 1990 this time. It seems to me SCs compared to LCs are just about as exspensive as any time in the last 20 years or so. What would be the rational for this to continue or am I missing something? I would likely guess that sooner or later LCs will catch up or SCs will catch down reverting to a mean. Fighting te trend can be a losing game I know but to me SCs seem very expensive relatively speaking of course. Why should SCs get more “expensive” if I am correct in my relative valuation assumption LOL?

    As always thanks for any reply a great websight

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