Keeping tabs on the relative performance of the US small caps (using the Russell 2000 or another US small cap index) vs the S&P 500 is always interesting. One of the several parameters that gives an understanding of the “market internals”

I would not say the “global fear trend” that has benefited the US equity market and most USD denominated assets is over.  The global fear trend and trade, simply long US assets and short everything else, started around the fall of 2010.  Though US small caps only started to under perform the big cap S&P 500 index around August 2011, but in the last 2 or 3 months the “fear trend” has definitely flattened out.

It’s these points in the cycle when a trade-able trend flattens out (in math terms the first derivative is close to zero) where the in-depth research and analysis of the fundamentals of the market, a specific industry and just as importantly the individual company/stock can lead to some significant trading opportunities. If the trend changes (first directive changes sign, positive to negative or vice versa) going forward, we look back at these points in the cycle as inflection points. Of course the difficult part is knowing in near real time that you’re at an inflection point to get in on the trade before it’s too late. Most don’t know that the trend has been in place for a while (including institutional investors, that’s why trends often accelerate near the end of the trade but with higher risk…see previous post on the Apple computer trade).  They hear about it from the media and get in after the most of the lower risk money has been made.

Courtesy of Russell 200 Index (US small caps) vs S&P 500 Index:

Russell 2000 Index (US small caps) vs S&P 500 Index
Russell 2000 Index (US small caps) vs S&P 500 Index

Notice that in the last two calendar years, late in the year the small caps go through a period of around 3 months or so of relative out-performance vs the large cap S&P 500. In late 2011, early 2012, the small caps staged a short-term relative rally that in the end was not able to break the dominant “global fear” trend. The same pattern may be happening again this year in 2012. The difference being today the US economic performance (trend in the economic data) is probably not good enough to support the current equity market valuation (see recent previous posts on recent US economic performance trends vs the US equity market valuation).  Also, keep in mind that historically November to April/May is, on average, the strongest performing part of the calendar year for the US equity market.

Another parameter that may be worth pointing out (I’m still researching this and will cover it in more detail another time).  The Russell 2000 small cap index is probably more reflective of the action in the US economy than the S&P 500 index of large global companies (the S&P 500 is really a global equity index as I’ve mentioned before).

Courtesy of Russell 2000 Index (US Small Caps) vs S&P 500 Index

Russell 2000 Index (US small caps) vs S&P 500 Index, long term (Point & Figure)
Russell 2000 Index (US small caps) vs S&P 500 Index, long term (Point & Figure)

4Q12 earnings season is less than a month away now. We’ll have a good picture of how the obvious slowness in the US economy in recent months is impacting corporate earnings (we saw it in the 3Q12 earnings actually, but that relative poor earnings showing was quickly forgotten)

This time of year I get a chance to go through some of my old market valuation models and graphs. As I update them, I’ll will try to share a few of the more interesting findings before year end.


Until next time.


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