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Much of the the research provided for this report came from our friends at Dorsey Wright and Associates. Dorsey Wright offers a free trial subscription, so feel free to check them out at dorseywright.com

The Small Cap area of the market has underperformed Large Cap investments year-to-date in 2014.
As of August 6th, 2014, the S&P 600 Small Cap Index [SML] was down -2.41%, and the S&P 500 [SPX] is up 3.89%.

We are getting asked “Is the run in Small Cap Stocks over?”
Keep in mind, this “run” in Small Caps is no little stretch. Small cap stocks have been leading other investment choices since early 2000 — that is now a “run” of 14 years. For most of this fourteen year period (nearly all of this time), small cap investments have been the sweet spot in the market for investors.

How Do We Know This?
One of the best tools we have gained in our work with Dorsey Wright is Relative Strength. Using relative strength, we can measure which area of the market, or which asset class, or which specific sector, or even which stock happen to be moving up faster (or slower) than the overall market, or measured against their group of peers.

Relative Strength is a powerful tool — but it is a long-term tool. So relative strength keeps us invested in the strong hands over long periods of time, and tells when it is time to throw in the cards, even if we just made a new investment last week.

We have a specific chart which measures the relative strength of SML (the symbol for the S and P 600 Small Cap Index) against the SPX (the symbol for the S and P 500, which contains larger cap stocks). This relative strength chart has been on a buy signal (favoring small cap investments) since February 2000.

Why is this important?
Look at the numbers: while this relative strength chart has been on a buy signal, the SML is up 217%, and the SPX is up 43% (through 8/6/2014).
This period covers most of the dot-com implosion, through the events of 9/11, the recession in 2001-02, the start of the Iraq War, the sub-prime melt-up in 2005-2006 and the subsequent financial sector melt-down, the recession and stock market collapse in 2008. And the bullish period since 2009.

What does this chart say today?
Today, even with the lagging performance so far in 2014, nothing on this chart has changed.

This relative strength chart comparing small caps [SML] and larger cap stocks [SPX] remains both on a buy signal, and is moving up in a column of X’s. This means we continue to favor SML (small cap investments).

Now over the past 14 years, there have been short periods of time when small cap stocks underperformed larger cap stocks. That is when the chart reverses to O’s. This has happened four times in fourteen years. However, not one of these periods have brought the chart to any point where it would have caused the relative strength chart to generate a sell signal.

A sell signal on this chart would cause us to re-examine the situation (favoring small caps). A sell signal might very likely make us consider reducing the amount we have invested in small cap stocks. And, if the market remained positive, we might also likely increase our exposure to larger cap names. So, no sell signal yet.

Keep in mind, a sell signal on a relative strength chart like this would be a very important signal.

As mentioned earlier, there have been four periods of time where this chart did reverse into a column of O’s. Remember, columns of O’s move down, while columns of X’s on a point and figure chart move up. When that happens (moving to a column of O’s), the chart is suggesting we will see near term weakness from Small Caps.

Today we are not far from seeing a fifth reversal into O’s.
In fact we are inching closer to a reversal to O’s.

To re-emphasize: a sell signal on this chart would cause us to re-consider our game plan with small cap investments. At this point, we are not close to a sell signal. But we are close to a potential move into a column of O’s, which would indicate weakness, on a short-term basis, in small caps.

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