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As the bottom panel of this excellent chart from Decision Point indicates, the January lows brought a potentially important shift in market strength. Up to that point, the largest components of the S&P 500 Index were outperforming the smaller components. That meant that the relative strength of the unweighted S&P 500 Index vs. the standard weighted version was in a downtrend. This occurs when investors and traders are seeking the relative safety of large cap names.

After January's lows, however, we've seen steady outperformance of the unweighted version of the S&P 500 Index. This suggests bargain hunting in the smallest of the issues within the index, something that occurs when investors and traders are relatively open to risk. (Note how outperformance of the unweighted index was characteristic during the bull phase).

Nor is this the only indication of bargain hunting among smaller stocks. At the January lows, 8% of S&P 500 large cap issues traded above their 50 day moving averages; that figure is now 22%. When we look at the S&P 600 small caps, we find that 10% traded above their 50 day moving averages at the January low; that figure is now 32%--notably stronger than the large caps.

Should we see a retest of the January lows among the large caps with nonconfirmations from the smaller caps, I would view that divergence favorably. We saw something similar during the 2002-2003 bottoming process and during the bottoming processes in 1998 and 1990. For that reason, I'm keeping a close eye on the number of stocks registering fresh 52-week lows as we move lower in the large cap averages.

Source: The Relative Strength of Smallcaps