Trader’s Narrative

While most of the attention is on the large caps which make up the major indexes like the S&P 500 and the Dow Jones Industrial, the small caps are continuing to outperform the wider market, even during this recent decline.

The 340 level on the S&P 600 index continues to be a major pivot:

Note the current price level for the small cap sector is higher than the February low (312). On a wider perspective, the relative outperformance can be easily seen in the lower panel which shows the relative strength of the small caps compared to their large cap cousins. The relative outperformance of smaller capitalization stocks is also clear if you look at the ratio of the S&P 500 stocks compared to the equal capitalization of the same index (for a chart see this link).

The same pattern can be seen if we look at the Nasdaq or a technology sector like say, the Semiconductor Index (SOX). Unlike the S&P 500 index, their current price is higher than their February lows. As well, the Nasdaq gained about 97% since the March 2009 bottom while the S&P 500 only managed a 80% return.

This is makes the recent cataclysmic drop in the Nasdaq newsletter bullish sentiment very intriguing. While this is not the lowest or even close to the lowest levels we’ve seen the Hulbert Nasdaq Newsletter Sentiment reach, it isn’t the nominal level of bearishness that has gripped my attention.

From the rapid and complete capitulation that took sentiment from 80% long to 45% short in just 15 trading days, you would imagine that the index had crashed - not dropped a mere 13%. So far, this drop is slightly more than the correction we saw in January (10%) but the sentiment response to is certainly asymmetrical.

So if you’re looking for opportunities on the long side, it would follow to seek out candidates from the sectors that have enjoyed the highest relative strength so far but are short term oversold and unloved.

Shifting Sands
I briefly touched on the fact that prices are below their long term averages now. I’m not worried about that too much as long as the slope is still upwards and as long as we don’t have a “death cross”. But I do see signs that the tone of the market has shifted.

Another sign of waning momentum is the S&P 500 index bullish percent which fell from its lofty perch to 44% today. Extremes in the bullish percent index are a sign of overbought or oversold during normal market conditions but just like the percent of stocks above their long term moving average, during high momentum conditions it tends to stick to the roof of the chart. From August 2009 it was hovering around 90-70% signaling that the market’s afterburners were lit.

If what I’m seeing is accurate, then it would be clearly visible only after a bounce higher. The magnitude and intensity of the rally as well as its staying power in being able to (or not) surpass previous highs would confirm for us whether momentum has really left the building.