Trader’s Narrative

The market is full of cycles. Some are fast and others like the inter-relationship between the small capitalization and the large capitalization subset play out at a glacial pace:

The stock market seems to go through these slow, vast cycles between large caps and small caps and they usually last about 5 years. Most surprisingly, they resemble a sine wave - with some noise thrown in - which is surprisingly orderly and predictable.

But we seem to be in a rare exception right now when the market can’t make up its mind who is winning and who is losing. Since 2005 we’ve been in a holding pattern with the ratio of small caps relative to large caps around the same level as 1994.

This is around the area where small caps have given up the fight and large caps taken over. Going back 30+ years the ratio topped out higher than this level (approximately 0.80) in 1984. So based on historical precedent, we should see large caps take the stage for the next few years.

The real question though is what does it mean? I’ve turned it over but I can’t detect any edge from this slow back and forth cycle. Especially for timing the market.

Having an idea of where we are in the over all scheme of things may be helpful if you’re going to go long one and short the other but it doesn’t seem to be all that helpful when you’re simply asking if it is a good time to short or go long either market by itself.

For example, while 1991 was a trough, it corresponded to the start of a period of years where the S&P 500 did quite well. But in 1994 where the ratio topped, that was arguably also a good time to buy. And then finally, in 1999 and 2000 when the ratio was pushed down again, that was not a good time to be invested in the market going forward.

Here’s an interesting chart comparing two slices of the US stock market:

In early April, around the time the stock market recovered from the March bottom, suddenly the Mid Caps (right axis) and the Large Caps (left axis) parted ways.

This is rather strange because they walked hand in hand for a very long time. I’m not sure why exactly. Even more puzzling, the S&P 400 Mid Capitalization Index (MID) also outperformed the S&P 600 Small Cap Index (SML) - not shown on chart.

Any ideas why the Mid Caps are hitting the sweet spot now?

The market does tend to go through drawn out cycles when the large caps and the small caps take turns leading.

Here is an updated chart of this relationship showing that maybe, just maybe, the small caps are about to regain the limelight:

And here is the same chart, this time comparing the Mid Caps to the Large Caps. No question here which is leading:

As the Mid Caps and Small Caps battle it out, one thing seems clear, the big cap stocks look like they are the losers going forward. If you want to take advantage of this you can switch out of SPY into an ETF like Rydex S&P Equal Weight (RSP) (if you’re feeling like a hedge fund, short SPY and then go long RSP). Or you could just buy small cap or mid cap ETFs:

• MidCap SPDRs (MDY)
• Vanguard Mid-Cap (VO)
• iShares S&P MidCap 400 (IJH)
• iShares Russell Midcap (IWR)