Yeah, Small-caps Are Leading, But Who Cares?

04/28/09 8:50 AM EST

Good Tuesday morning...We begin the day with another bout of pre-market weakness as flu worries (of both the physical and financial kind) wind their way across the markets.

I'm wary of reading too much of an economic impact into the flu just yet, as this has a similar ring to the headline-grabbing panic of SARS from 2002.  From the blog yesterday morning:

It's hard to try to gauge the risk of something unknowable like the spread of the swine flu, but sometimes it's just as hard trying to gauge the importance of something we do know.  Like the recent out-performance of "junk" stocks.

Kind of like the merit of gold stocks, the argument between small-cap versus large-cap and growth versus value always stirs up a hornets nest.  Investors are passionate about those subjects, and any suggestions counter to their beliefs bring out the barbs.

Research surrounding all those topics are well-worn and I usually avoid them.  But I received quite a few questions yesterday after the Wall Street Journal posted a story titled "Trash Is King", noting how the recent rally has been dominated by beaten-down stocks.

This reminded me of many similar references we saw during the 2003 rally, such as this one:

Usually the argument goes that we should see high-beta stocks lead out of a market bottom as risk-taking behavior returns, but then we need to see buying interest morph into more "quality" issues, which is usually just another name for large-cap stocks.  "Trash" stocks are usually a not-so-nice euphemism for the stocks that litter the small-cap indices.

I'm not going to get into the whole large-cap versus small-cap debate.  They trade on their own fundamental merits related to valuation, economic prospects, momentum, etc.  All I intend to do here is look at how small-caps (represented by the Russell 2000 index) has performed against large-caps (the S&P 500) during prior market bottoms.

Unfortunately, the data only goes back to 1978, so we can see the lows during the 1930's or 1970's.  I'm not sure that's such a huge deal in this case, because of how much the market has changed during that time, so I still think there is value in looking at the past 30 years.

First, let's start with a big-picture chart of small-cap versus large-cap performance.

During the three big stretches of small-cap out-performance, the S&P averaged a return of +41%.  During the three blocks of under-performance, it averaged 91% with slightly fewer trading days.  But small-caps were under-performing heading into the 1987 crash, and also the current bear market, so it's not like this is a great timing indicator.

Before we look at some prior market lows, let's sneak a peak at the prior bear market to see if we can discern some pattern there.

Maybe it's just me, but I can't find much there.  Small-caps took a quick dive immediately after the low each time, but then out-performed large-caps during the failed rallies in 2001.  During the failed rally in the summer of 2002, they under-performed.

Well, let's look at a handful of market lows and see if anything more consistent pops up.

In 1982, small-caps dipped initially, then powered higher as the rally gained steam.  This was certainly not a case where we "needed" to see investors rotate to large-cap stocks, at least not during the first year.

It was a fairly similar situation in 1987.  Small-caps under-performed right away, then quickly jumped ahead of their bigger brothers.  After a few months, investors did move away from smaller-cap stocks as the market rallied into early 1990.

At the 1990 low, once again we saw a brief spurt of large-cap buying in the first few days, then small-caps took over.  They continued to pace the market for most of the next three years.

By 1994, we were witnessing a sea change.  Unlike each of the previous lows, this time small-caps were leading heading into the market bottom, and then under-performed as the rally matured.  This is in stark contrast to each of the previous ones we just looked at.

Small-caps were also under-performing heading into the 1998 low, then enjoyed a brief respite during the first month of the rally.  After that, they rolled right over and continued their under-performing ways as the market rallied into the ultimate peak in 2000.

At the last bear-market low, small-caps had been out-performing for most of the prior three years, but then took a relative beating in the months before the low in October 2002.  That continued during the first couple weeks of the thrust off the low, then they out-performed going forward, which pretty much continued into 2006.

OK, so what does it look like now?

The big gray arrow on the chart sums it up - there hasn't been much of a theme since the current bear market began.  Small-caps out-performed during early 2008, then under-performed during the fall and again this spring.  The overall market declined that whole time, so I'm not sure what the message would be from that.

Unlike each of the other charts we looked at with the exception of 1998, this time small-caps have out-performed right from the get-go.

So what does that mean?  Based on the charts above and the long-term relative strength relationship between small-caps and large-caps...I have no clue.  The point is that based on this particular look of "trashy" stocks versus "quality" stocks, there hasn't been any consistent pattern coming out of market bottoms, bear-market or otherwise.

When we read quotes like the one in the Journal from Monday, then, we should be casting a wary eye on any conclusions they're drawing unless it's backed up with some solid evidence that so far has been lacking.

Bottom line - Intermediate-term

Beginning in early March, we discussed a large number of reasons to expect an imminent rally of one to three months' duration.  Some of those studies were even more positive, and suggested not just a rally, but possibly a new bull market.

After the 20%+ rally, our current juncture is somewhat similar to where we were in January of this year.  On the one hand, we have a number of studies based on past behavior that suggest more upside to come.  On the other hand, we have things like the Indicator Score, Dumb Money Confidence and other potential roadblocks like we discussed recently.

The market has held up well in spite of some short-term overbought conditions and other situations when it rolled over immediately before, which is a point in favor of further upside.  But when looking at our current position objectively, it's hard to find a solid edge given the battle between the studies (which point higher) and the current status of many of our indicators (which had become considerably negative for the market).

It's possible that we're in an "April 2003" kind of place and we'll just keep steaming higher as we emerge from the bear market, as some of those studies from last month suggested.  I'm not comfortable betting on that possibility, and prefer to back off and look for shorter-term opportunities in what I think will most likely be a multi-week or multi-month trading range between 850-875 on the upside and 730-760 on the downside.

Given what we've discussed over the past few weeks, I was inclined to believe that the push above the recent high at 860 would be a false breakout, and last Monday's huge down day after challenging 875 helped confirm that view.  That also broke the uptrend line from the March low, and on Friday we witnessed another rejection of that 875ish area, which adds further confirmation of the strength of that resistance.

Bottom line - Short-term

Yesterday morning, I was most interested in watching how the market performed after the first hour of trading.  Our shortest-term indicators were modestly overbought, and given the large gap down after two straight up days, a lower low after the first hour would have most likely led to additional selling pressure into the close.

We didn't really get that, as the S&P rallied right from the open, nearly recovering enough to close the gap from Friday's close.  It couldn't quite make it, and instead slid to close not from from where it opened.

If we continue to sell off this morning, it would mark only the third time we've seen back-to-back opening gaps of -1.5% or more this year (the others were on January 23rd and March 2nd).  There have been 14 of these since the inception of the S&P futures, and buying the open of the second day's gap was mixed.  It led to a close higher than the open 50% of the time and an average of +0.1% - no edge there.

Over the next few days, it got better, with a winning percentage of 64% and average return of +2.4%.  Two weeks later, the S&P was up 79% of the time with an average of +3.7%, but it was extremely volatile (the average risk during those two-week trades was -5.3% compared to an average maximum reward of +8.7%).

Remarkably, during the current bear market the S&P was positive two weeks later 8 out of 9 times by an average of +3.4%.  But (and this is a big "but"), the other multiple gaps occurred after the market had sold off, not when it was coming off a multi-month high.  That's a big difference - we're probably not seeing capitulation here as we would be if we'd been selling off for the past couple of weeks.

I still see very little in terms of possible edges here in the short-term, and am basically doing no trading.  The moves have been extremely erratic and whippy, which is perfect for some trading styles but not so much mine.  And with continued headline risk from the flu and upcoming stress test results, I'm not at all inclined to try to risk capital without what I feel is a solid edge.

All the best,