The Current Relative Strength of Small Caps

by | Oct 9, 2014 | Podcasts, Stock Market Comments

The small cap swoon has continued into October and we’ve repeatedly heard advisors, the financial media, investors, and clients ask, “Is the run in small caps over?”. If you’d like our opinion at Mullooly Asset here it is: maybe. Not the answer you were looking for? Tom digs further into this question during the weekly podcast, and by the end of it you’ll understand why we cannot definitively say yes or no just yet.

Throughout 2014 small caps have underperformed the broad market, as represented by the S&P 500. However, we’ve yet to see a relative strength sell signal from small caps when compared to large caps. A relative strength sell signal would confirm that small caps have moved out of favor compared to large caps. A relative strength sell signal would also tell us that the run of outperformance in small caps is indeed finished. We’re still waiting for that signal.

The past month’s market volatility has brought us close to that small cap relative strength sell signal. Note that it’s close, meaning it hasn’t happened yet. One of the rookie mistakes of point and figure charting (or any technical analysis really) is to anticipate a move on a chart. We wait for confirmation, especially with longer term indicators like relative strength buy and sell signals. To remind everyone, small caps gave a relative strength buy signal versus large caps in January 2000. This buy signal has persisted for 14 years! This is why we don’t anticipate moves and toss a long term trend to the curb without receiving confirmation.

So what’s up with the recent volatility? Last week we had four of five trading days bring market moves of more than 1%! We’re talking small caps and the rest of the markets too. Tuesday, the Dow and small caps were down 1.5%. Yesterday, the markets surged up 2% after news from the Fed. We can see a lot of back and forth movement in the market, but what we’re concerned with are the longer term indicators like relative strength. Are the serious market trends still intact? For now, yes. Again, we do not anticipate the indicators.

When something does give a relative strength sell signal, does that mean we absolutely must sell it all immediately? No. What it means is that there are likely better places to invest. Underperformance is relative. For example, if the market returns 12% over the next 12 months, something on a relative strength sell signal could return 11%. It could also lose money. Underperformance is what relative strength defines for us. When something is on a relative strength sell signal, we have to watch it closely to determine if it’s something that we should continue investing in.

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