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Are Small Caps And Growth Stocks Flashing A Warning Sign?

|Includes:IWM, SPDR S&P 500 Trust ETF (SPY)

At any time, the health of the market trend can be characterized by changing relationships between various sectors of the market (i.e. small caps versus large caps) as well as inter-market behavior (i.e. gold versus equities). One of the sector relationships followed by Baseline Analytics is the relative performance of small cap vs. large cap equities, as well as growth vs. value equities. The current state of these relationships suggests that the market uptrend may be feeling a bit tired.

The chart below depicts a ratio between small cap stock performance and large caps. The darker (red/black) line is the ratio, while the pink like is the S&P 500.

(click to enlarge)Click to enlarge

Note that the strongest performance in the S&P 500 tends to be accompanied by a rising small cap vs. large cap ratio. A rising ratio suggests increased tolerance toward risk and, at extremes, tends to represent excessive bullishness. A peaking of this ratio, although not necessarily negative for stocks in general, tends to introduce a more defensive market posture as larger, dividend-paying stocks are favored. The small cap/large cap ratio appears to be topping (note the resistance as denoted by the blue line) while its relative strength index (RSI at the top of the chart) has been on a slight downtrend. This would suggest an increased preference for more defensive, large cap issues.

We can see a similar peaking activity in growth vs. value stocks. On the chart below, the RSI of growth vs. value became quite overbought as RSI has recently fallen below 70. Note the red-boxed areas where value outperformed growth. This is also depicted where the ratio has fallen below its 50-week moving average (the smooth blue line). This condition tended to correspond with a sideways or correcting S&P 500 (see the lower portion of the chart below).

(click to enlarge)Click to enlarge

You will note that the relationships depicted in both charts are not perfect, and there are timeframes whereby the expected results do not pan out. However, Baseline Analytics relies on signals and warning signs to assess the risk of the current market trend changing. The small cap/large cap ratio and the growth/value ratio are only a small part of the arsenal of technical tools that can be used to assess market risk and manage investment portfolios wisely.

- Baseline Analytics

Stocks: SPY, IWM