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Option Millionaires was started in February 2008 to provide traders with information about option trading. Led by three career option traders, whose pseudonyms are JimmyBob, UraniumPintoBeans, and Vantillian, they started one of the most popular option trading communities on the web. Now, Option... More
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  • Short Term, There's One, Small Cap, Chink In The Market's Armor 0 comments
    Mar 23, 2013 4:37 PM | about stocks: IWM, SPY, DIA, QQQ, SPYG

    By all means, on a longer term basis, the American market looks fantastic. However, in the past week, the risk of entering new into new long positions via ETFs (not single stocks) appears high. Why? Small cap stocks have been losing ground over the past few days, unlike the "major" indices. These "major" indices that investors generally look at are the Dow Industrials, S & P 500, and the NASDAQ Composite. The Dow and S & P 500 give a view of how the 530 largest companies' stocks are performing, ignoring the performance of smaller companies. The NASDAQ Composite, while comprised of around 3000 stocks, is essentially also a large cap index. To get a better understanding of why this is so, take a look at the index's top ten weightings.

    AAPL - 20.21%

    MSFT - 8.06%

    GOOG - 5.75%

    ORCL - 5.06%

    INTC - 3.62%

    AMZN - 3.59%

    QCOM - 3.44%

    CSCO - 3.14%

    CMCSA - 2.25%

    EBAY - 1.99%

    So, ten out of 3000 companies in the index represent about 57.12% of the index's movement. Even more surprising, the top 50 companies in the index are responsible for around 85.33% of its movement. Therefore, the smaller companies beyond the first few hundred in the index do not really affect it much. The NASDAQ is a large cap index.

    When monitoring the performance of smaller companies, my index of choice is the Russell 2000 ($RUT). Year to date, the Russell 2000 has performed exceptionally well, outperforming all of the large cap indices. See the chart below for a comparison of the Dow (black), S & P 500 (blue), NASDAQ Comp. (green), and the Russell 2000 (brown) since January 1.

    (click to enlarge)

    While it is typical to see small and mid cap stocks outperform their large cap peers in a bull market, these stocks are also the most sensitive to when the market mentality turns to "risk-off." Very often, small cap indices like the Russell 2000 start to underperform before short term tops and corrections. In addition, small cap stocks often enter bear market territory long before large caps during major market tops. As you can conclude from the chart above, with small cap stocks still dominant, the probabilities do not favor that a major market top will occur in the near future.

    So, while the Russell 2000 is an outperformer in the longer term, its short term performance tells a different story, which is why I'm not quite convinced that this current correction/sideways correction has concluded yet. Take a look.

    (click to enlarge)

    This chart shows that, while the roughly 630 largest stocks in America have trended sideways over the past week, in aggregate, 2000 smaller ones have moved lower, in aggregate. This short term weakness could spread to larger cap issues, which could cause the market to drift lower in the short term. I do expect a breakout to occur eventually, which should place the Russell back into its leadership role, but until then, investors should be aware of the potential for a further pullback.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Stocks: IWM, SPY, DIA, QQQ, SPYG
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