Large Caps Yay; Small Caps Nay

Posted At 8:35 AM EST

Good morning...We begin the day with some buying interest in the pre-market futures.  Last week when we got a big gap up on Monday, it turned into a monster trend day to the upside, but the just-released Retail Sales report is causing some volatility so we'll have to see if the gap sticks into the open of regular trading.

There has been a whole host of divergences lately as some of the major indexes like the S&P 500 have pushed to a new one-year high.

We're not seeing some sub-sectors break out along with the S&P (such as financials, energy or semiconductors), market breadth has been lagging (even the breadth of the S&P 500 itself), and some other indexes like the Russell 2000 have been struggling.

That last one is starting to get quite a bit of attention, as analysts make the argument that the weak dollar is benefiting large cap stocks that are contained in the S&P much more than the small cap stocks in the Russell.  Others view it as a shift in sentiment from riskier stocks in the Russell to "safer" stocks in the S&P without having anything to do with overseas sales.

Whatever the reason, it's commonly believed that a divergence like this is a bad sign for the market going forward.  So let's take a look.

What we're looking for are any times since 1978 that the S&P scored a new one-year high, but at the same time the Russell 2000 was at least 4% below its own one-year high.  Like now.

Here are the returns for the two indexes going forward:

There were 18 occurrences, and overall the returns going forward weren't too bad, especially longer-term.  When looking out six months, for example, the Russell was positive 72% of the time and the S&P 83% of the time.

Relative to each other, the Russell out-performed the S&P shorter-term (67% of the time after one week and 56% after one month), they were about even after three and six months, but after one year the Russell lagged the S&P 12 times out of the 18.

As an added twist, let's look for any time that both indexes had made a 52-week high within the past month, as they did this time.  Doing this will really isolate those cases where the Russell just recently took a dive from a recent high while the S&P held up.

Unfortunately, there was only one instance.  And even more unfortunately, that one instance was March 24, 2000.  For all intents and purposes, that marked the end of the great 1990's bull market.

Let's relax that a bit and look for times when both indexes had hit a new one-year high within the past three months.  That gives us six occurrences.  The charts below are in descending order from the most recent, with the performance of each index below the chart.

Overall, the Russell 2000 managed a positive return a month later only one time, in 1991 when it burst higher in the short-term then petered off over the next several months.  Longer-term, its results were mixed, so I would say it tended to lead to poor shorter-term returns and inconclusive longer-term returns.

For the S&P, it was considerably better.  While the next few months were mixed, the longer-term results were markedly positive except for the last occurrence in 2000.  The other five all showed double-digit gains when looking out one year.

As for large caps relative to small caps, the S&P out-performed the Russell when looking out three months every time but once (in 1991), and four times out of the six when looking out a year.

Bottom line, should we be worried about this divergence based on how the market has reacted previously to similar circumstances?  Perhaps in the short-term of several weeks, as the market tended to under-perform any random time, especially in the small caps.  The under-performance wasn't dramatic, but it was enough to be concerning.  Longer-term, however (several months at least), there isn't anything consistent I could find among the results that would suggest wringing our hands about.  The divergence in 2000 was an obvious exception...but it was the exception.

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Intermediate-term Signal Strength:    Neutral since Apr 9th (843 SPX)

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Beginning in early March, we discussed a large number of reasons to expect an imminent rally of one to three months' duration, or possibly even a new bull market.  During April and May, we went over several studies that suggested that "this time is different" in terms of bear market rallies, as we reiterated in early May.

Since July, the market has consistently rallied smartly from the shortest-term oversold readings, as a healthy market does, and it has rolled over almost all hints of bearish conditions.  That kind of momentum tends to persist for long periods of time.

We've seen some periodic bouts of excessive optimism along the way, and the market has pulled back in the very short-term after them.  But each time, the major indexes have held technical support, and rallied from even intraday oversold readings, so we've seen little change in the uptrend's character.

Over the past week or so, we've gone over a few modestly convincing studies that show some cracks in the uptrend's potential.  We're seeing some very volatile swings in breadth, a deterioration in the number of stocks rising along with the market, a number of big reversals after tests of recent highs, and a hesitation to rally from short-term oversold readings.

All of these were warning signs, and the S&P subsequently broke the uptrend line from March.  However, during the recent correction we also saw investors quickly switching to the "excessive pessimism" side of the ledger, and the market quickly bounced back.  That's very healthy behavior, and if the S&P can break out over 1100 and hold for more than a day or so, there will be little to complain about regarding its performance.  For the time being, we are essentially stuck between 1020ish and 1100, and given the conflicting data from above, we're not too keen on being exposed long or short on an intermediate-term time frame, but we'd have to tilt bullish if we can break out and hold 1100.

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Short-term Signal Strength:  Neutral since Oct 5th (1029 SPX)

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Last week, the market faded as it "should" have from a large gap up opening on Wednesday, following through with that on Thursday.

The selling pressure wasn't enough to trigger any notable extremes among the majority of short-term indicators we follow, and we were also seeing the kind of behavior among Rydex mutual fund traders that has usually led to even more of a correction.

Large gaps up on a Monday have been a boon to the market since March.  Out of the 8 times we've seen it since mid-March, the S&P has added to its opening gain every time by the close (though the next couple of days have been mixed).  When it occurs during the week of an option expiration, historically Monday morning gaps have mixed (showing a positive return 50% of the time), so nothing especially notable there.

With almost everything I look at neutral for the short-term, I don't see much edge here and once again the big test will be the first hour of trading.  With the gap open right at the previous high, if we're going to fade then it should be right away.  But if buyers are eager enough to push us to new intraday highs after the first hour - and to a new one-year high, then I don't see enough evidence to want to fight that momentum.

All the best,