SUBTLE SHIFT OUT OF SMALLER STOCKS COULD BE AN EARLY SIGN OF A MARKET TOP -- THE SAME IS TRUE OF RECENT STABILITY IN THE DOW INDUSTRIALS
SMALL CAPS ARE STARTING TO SLIP ... One of the more subtle changes that took place this past week was slippage in small cap stocks. The slippage wasn't substantial; nor has there been any serious chart damage done. But it's something that bears watching. That's because the relationship between small and large cap stocks tells us something about the overall trend of the market. The first two charts compare the last three months' price performance of the Russell 2000 Small Cap Index (Chart 1) with the Russell 1000 Large Cap Index (Chart 2). During the fourth quarter, the two indexes rose in tandem (although small caps were the stronger of the two). Some subtle changes have taken place, however, since the start of the new year. The small cap index hit a record high on February lst while the large cap index peaked on January 11 and has since fallen below its 50-day average. In the two weeks after January 11, large caps fell while small caps continued to rise. Part of that may be the January Effect which usually favors smaller stocks. Since Febuary 1, however, small caps have been falling as well. Over the last week, they actually fell more than large caps for the first time in three months. That can be seen more clearly in Chart 3 which is a ratio of the Russell 2000 divided by the Russell 1000. The ratio climbed at the start of the January (green circle), but has turned down this week (red circle). So far the slippage of small stocks is relatively minor. But it bears watching because the market does better when small stocks are leading it higher -- and worse when small stocks turn weaker.
Chart 1
Chart 2
Chart 3
WHY SMALL CAP SLIPPAGE IS TROUBLING ... It's not unusual to see to see rotation out of smaller stocks near the end of a bull cycle. Money typically migrates from riskier shares (which are usually smaller) and toward shares that have the potential to offer higher stability (usually large shares). That change usually occurs early in a topping process. One of the best ways to monitor that change is to use a relative strength ratio of the two indexes. Chart 4 shows the RUT:RUI ratio over the last eighteen months and shows its impact on the S&P 500. Notice that the two previous peaks in the small cap/large cap ratio (first two red arrows) coincided with downside corrections in the S&P 500. The last two upturns in the ratio (green arrows) coincided with rallies in the S&P. That seems to demonstrate that small cap leadership is necessary for the market's uptrend to continue. It's too early to call this a significant peak in the ratio. But it's the biggest drop so far in 2006. And the 9-day RSI line shows that ratio moves into overbought territory over 70 (see blue circles) have resulted in downturns before. It's an early warning signal that bears watching.
Chart 4
DOW STRENGTH MORE BE A DEFENSIVE MOVE... On Thursday evening, the Dow Industrials were the only one of the big three market indexes to close over its 50-day moving average. The Nasdaq and the S&P 500 closed beneath that support line. That suggests that the Dow is holding up better than the other two. The stronger performance of the Dow can be seen more clearly in the relative strength ratio at the bottom of Chart 5 which plots the Dow divided by the S&P 500. Notice that the ratio has jumped noticeably over the last two weeks. Is there a message in that? There may be if investors' preference for Dow stocks suggests a choice of money seeking more of a safety net. That's because the Dow is viewed as an index of more stable stocks. The fact that the Dow is starting to hold up better than the S&P or the Nasdaq may also be suggestive of topping action in the broader market.
Chart 5
THE DOW OUTPERFORMS IN A WEAK MARKET... Historical trends seem to support the view that Dow outperformance is usually a negative sign for the rest of the market. Chart 6 plots a ratio of the Dow divided by the S&P over the last ten years. Notice that the last major upturn in the ratio (first red arrow) in 2000 coincided with a major market top. The last downturn in the Dow ratio in late 2002/early 2003 coincided with a major upturn in the market. Although the monthly ratio is starting to bounce, it's too soon to call this an important upturn. The 9-month RSI line, however, suggests that it may be. The Dow/S&P ratio is now in the most oversold territory since early 2000 and late 1998 before then. That would suggest that this is a logical spot for the Dow to start to gain ground on the S&P 500. If it does in a meaningful way, however, that may be a sign that investors are turning more defensive and are moving into Dow stocks as a form of protection. Incidentally, that's essentially the same message that we would be getting if money started flowing out of riskier small stocks into more stable large stocks (especially those in the Dow).
Chart 6
EDITOR'S NOTE: ... Jeanette Schwarz Young was a contributing writer for this article and the source for most of the data. Ms. Young is a trader on the New York Board of Trade and an experienced technical analyst and writer.
