December 14th, 2010

Large Cap or Small, the Argument Continues

It seems that the final few weeks of the year are always the time that financial commentators look at the relative performance of large and small cap stocks and conclude that this is the year that large will finally outperform small. At around this time last year, in “Large or Small, That Is The Question?” of December 7, 2009, I commented about a NYTimes article in which Mark Hulbert quoted a report of Jeremy Grantham’s in which they concluded that:

“…the performance gap between the weak and the strong has rarely been as pronounced as it has been since March’s market lows. The extreme outperformance of the more speculative stocks could make them vulnerable to another market shock…..’high quality stocks are about as cheap as they have ever been relative to shares of firms with weaker finances. It’s almost a certain bet that high-quality blue chips will outperform lower-quality stocks over the longer term.”

The following week in “Large or Small, A Correction” on December 13, I responded that the 2010 game plan rests on:

“…..whether you’re looking for a market correction in the new year or a resumption of the bull market. As I’ve written before, I see both happening next year …. a correction first followed by new highs later in the year. The small caps, since they’ve had the greatest gains this year may have already consolidated and will lead the market higher next year. A quick and not overly steep consolidation after New Years will be concentrated in the large caps.”

Here we are, again in early December, and Paul Lim now writes in the NYTimes

“….many market strategists argue that the recent surge for small-cap stocks might turn out to be a good omen for shares of large domestic companies….The performance of small stocks could also be viewed as a sign of confidence that the global economy is on the road to recovery. And that means the bull market in equities that began in March 2009 could live on to a third year — which is another potentially positive development for blue chips….

  • Sam Stovall, chief investment strategist for Standard & Poor’s, says ‘in the third year of a bull market, investors prefer larger boats, as they expect the seas to become a bit more treacherous.’
  • James B. Stack, editor of the InvesTech Market Analyst newsletter and a market historian, agrees. ‘Historically speaking, as bull markets age, investors tend to grow more conservative. I’ll be surprised if we don’t see the S.& P. 500 perform as well or better than small caps in 2011.’
  • ‘Small-cap dominance could be ending if central banks around the world start signaling that they are confident enough in the recovery to start hiking short-term interest rates,’ said James W. Paulsen, chief investment strategist for Wells Capital Management.
  • ‘Frankly, I find valuations on large caps much more compelling than for small. From the standpoint of a contrarian investor, when you see something happen for 10 years, you shouldn’t expect it to continue to outperform over next 10 years.’ said Thomas H. Forester, manager of the Forester Value Fund.”

According to these pros, the deck certainly seems stacked against small caps. But they’re not technicians and don’t put much stock (no pun intended) in what this chart says (click on image to enlarge):

The two indexes (Small cap in black, large cap 500 in blue) moved surprisingly in unison until the “dash for trash” small cap bull market of 2009. While the S&P 500 was stuck in its 12-month horizontal consolidation trading range (which sure didn’t feel like a consolidation while we were going through it!), small caps were volatile but continually forged ahead. I have two takeaways from this analysis: Buckle your seat belts, folks, this could be a spectacular year if you’re in nearly any stock.

  • Small caps have formed a huge inverted head-and-shoulder and you know how these patterns have turned out to be among the most reliable among all chart patterns. By conventional rules of thumb, if this is truly an inverted head-and-shoulder pattern, the small caps just crossed above the neckline then the move might only be half over.
  • Large caps have been laggard and next year could play catch up with many of those stocks actually doubling by next year end.

As the year progresses, the question will increasingly be whether the market is expensive and overvalued, whether declines are corrections or peaks and when will it be time to take some money off the table. It’s times like these that a proven market timing tool like the one that my subscribers see in each of my correspondences will come in extremely handy.

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