Trader’s Narrative

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)

Around the time that the internet bubble burst, small caps started to outperform large cap stocks. And they continued to do so through the bear market and the subsequent bull market.

Now it seems that large caps may be getting the upper hand once again. Here’s a chart of the S&P SmallCap 600 compared to the S&P 500 index:

Any ideas why the market prefers small caps to large caps? It may have something to do with the weak dollar and how the large caps have international earnings which are now “worth” more in dollar terms. But really, I have no clue.

Looking at the percentage of stocks above their 50 day moving average is a quick and dirty way to find out where the market stands in the medium to short term. Looking at the percentage above 200 day moving average provides a much broader perspective.

Line In The Sand
The 200 day moving average is like the proverbial “line in the sand”. If a stock can’t hold above it, technically speaking, things are really rotten. But while that may be negative for one individual stock, when as a whole the market crosses that threshold, it usually is a sign that things have reached an extreme and are about to return to normal.

Right now, the percentage of stocks above their long term moving average are at levels which in the past have seen a resumption of the bull market. The index that got the most oversold was the Nasdaq Composite (COMPQ) which reached 34%. The next one was the S&P 500 (SPX) which got as low as 43%.

Large Cap vs. Small Cap
But there is an obvious dichotomy. Whereas the broad indices (containing a mix of small caps and large caps) show an extreme low reading for this indicator, the large caps are almost unscathed. The Nasdaq 100 (NDX) index, for example, has 60% of stocks above their 200 day moving average while the S&P 100 (OEX) has 62%.

This is no surprise since we all know that the small caps have gotten crushed in this correction. A cursory look at the Russell 2000 (RUT) shows it correcting about 12% (from recent high to recent low) - almost double that of the large caps.

Unless for some reason you believe that we are heading into a new bear market, this is as bad as it is going to get. I reiterate that this is a buying opportunity if you have a medium to longish time horizon. Especially the financial sector.

Here’s the chart for the NYSE and the S&P 500. Notice the difference between a bear market bottom and bull market inflection points: