SIX-YEAR SMALL CAP DOMINANCE MAY BE ENDING -- REITS AND TELECOM ARE DOING BETTER -- SO IS DJ DIVIDEND ETF

DIVIDEND ETF IS OUTPERFORMING ... Last Friday I showed a few defensive groups that were showing upside leadership including consumer staples, pharmaceuticals, and utilities. Here's another one. Chart 1 is a daily bar chart of the DJ Dividend Index iShares (DVY) through the first six months of 2006. The chart itself isn't terrible exciting. Although the DVY is trading above both moving average lines, it's shown a very choppy pattern since the start of 2006 with a slight upward bias. What's more noteworthy is the DVY/SPX relative strength ratio at the bottom of the price bars. That line shows a very noticeable pattern of outperformance that started at the end of April. I suspect that trend is based on several factors. And all of them suggest that investors are in a more defensive mood. For one thing, large cap stocks are starting to do better than small caps. Within the large cap universe, investors are shifting toward more defensive areas that pay dividends. That's where this particular ETF comes into play. It's a large cap fund that holds stocks that pay dividends. Most of them are in the defensive category. The biggest stock holding is Altria (MO) which surged to an all-time last week on a favorable tobacco ruling. The three biggest groups represented are financials, utilities, and consumer staples. [Other groups included are basic materials, healthcare, and oil & gas]. That means that the DVY overlaps to some extent with other ETFs that cover consumer staples and utilities. But it does provide another defensive vehicle in an uncertain market and a slowing economy.

Chart 1

IS TIDE TURNING AGAINST SMALL CAPS?... After six years of doing better than large caps, the tide may be starting to turn against small cap stocks. For one thing, six years of outperformance is long by historical standards. A shift to large cap stocks is probably overdue. Although evidence is far from conclusive, small caps have done much worse than large caps over the last three months. That can be seen on Chart 2 which is a ratio of the Russell 2000 Small Cap Index (RUT) divided by the Russell 1000 Large Cap Index (RUI). Prior to its recent rebound, the small cap/large cap ratio broke the rising support line drawn under its 2005 lows. It's too soon to call that a major downturn. A long-term look at the ratio, however, shows that this would be a logical spot for small caps to start underperforming.

Chart 2

SMALL CAP LEADERSHP HAS REACHED OLD EXTREME ... Chart analysis can be performed on ratio charts just like any other index. That includes the study of long-term support and resistance levels. Chart 3 shows the Russell 2000/Russell 1000 ratio line over the span of fifteen years. The first yellow circle in 1994 marks that last time small cap dominance ended (after a four-year run starting in 1990). After falling from 1994 to 1999 (five years), the ratio turned up in 2000 and has been rising since then. Notice, however, that the RUT/RUI ratio has reached the old peak hit in 1994 (second yellow circle). That doesn't mean that the ratio has to turn down from here. But it's a logical spot for that to happen. That's one of the reasons that I've taken the recent downturn in small caps more seriously. And it would seem to support the idea that the tide may finally be turning away from small caps and back to the large cap stocks. If the recent downturn in small caps is an early sign of a market top, it makes even more sense to switch to dividend- paying large cap stocks that are generally resistant to an economic slowdown (like consumer staples). Chart 1 suggests that's just what investors are doing.

Chart 3

REITS AND TELECOM ARE DOING BETTER ... I would be remiss if I didn't point out that REITs have also shown better relative strength of late. [That's in stark contrast to homebuilding stocks which have been one of the market's weakest groups over the last year]. Here again, I suspect the defensive qualities of REITS (along with their high dividends) has drawn money back into this group. Telecom has also been doing much better. Chart 5 shows the Telecom Holders (TTH) nearing a test of their spring high. Their relative strength line has already exceeded that barrier and has been rising since May. That's right around time that the rest of the market (especially the more economically-sensitive parts and small caps) started to run into trouble.

Chart 4

Chart 5

CASH IS IN A BULL MARKET ... A wise man once said "there's always a bull market somewhere". Recent bull markets in small caps and emerging markets (and some commodities) have come under selling pressure over the last three months. One bull market that's still going strong, however, is "cash". Chart 6 shows the 3-month Treasure Bill yield reaching 5% after rising for the last two years. That's due primarily to the Fed's rate hiking campaign that started in the summer of 2004. It's hard to argue with a money market fund paying a risk-free 5% in an uncertain market environment. One of our readers asked recently if I thought cash was a good place to have some funds at this point in time. I've said so on many occasions. A May 16 message entitled "A Summary of My Market Views" advised a more defensive approach to the market which included lightening up on commodities and emerging markets and moving toward consumer staples and healthcare. It also included the sentence: "The safest place to be for money coming out of the market is a money market fund". And that will continue to be the case until the Fed stops raising rates or until a better buying opportunity emerges this autumn.

Chart 6