This column was originally published on RealMoney on July 18 at 7:56 a.m. EDT.
For the past two years, small-cap stocks have powerfully outpaced their large-cap brothers and sisters. From April 2003 through this week, the S&P Small-Cap 600 index is up 85%, nearly double the 45% gain of the Russell 1000 large-cap index.
So as traders, we didn't need to exert the usual amount of effort figuring out what sectors to own in order to beat the broad market. We just needed to buy a diversified bunch of smaller stocks with decent fundamentals. Pretty simple, to be honest.
Within this paradigm, though, there has been a deeper divide. That has been the relationship between your basic small-cap stocks and the mainly large-cap tech and biotech stocks of the Nasdaq 100. And what's interesting in the contrast between these two groups is that their relationship has waxed and waned with a certain regularity.
As you can see in the chart below -- which shows the ratio between the exchange-traded fund tracking the
and the exchange-traded fund tracking the
( QQQQ) -- the small-caps' outperformance over the large-cap techs rose sharply in 2001 and 2002 to a triple peak of 1.70, 1.77 and 1.71.
After that, starting in October 2002 and running until the start of the Iraq war in March 2003, large-cap tech strongly outperformed the small-caps. At that latter point, the small-caps took over again and beat their bigger elders through the end of last week.
The new part of this story now, shown in the green box highlight, is that the relationship peaked almost exactly where it peaked last time -- back in the summer of 2002. It's hard to say whether this is a coincidence. For now, I'll just say it's something that bears watching, and in the short term it's something worth trying to exploit for a couple of trades, which I'll get to in a moment.
So how far could the relationship reverse, if that's what is happening? You'll see that I drew in a blue uptrend line that connects prior lows in this move. There are four touches, which makes it somewhat significant, if not completely persuasive. If the pattern were to hold, we could forecast that small-caps would be due to resume their outperformance vector once the ratio got back to around 1.62. At the current pace, it would probably take a couple of weeks.
Small-Caps vs. Large-Caps
On Thursday, the difference between the two groups of stocks was dramatic: The Small-Cap index was down about 0.75% while the Nasdaq 100 was up nearly 1%. That drove the ratio down quite a bit -- 0.5 points, to be exact, as you can see in the upper right corner of the chart. But keep in mind the small-caps don't actually have to go down for the ratio to decline; they only need to go up more slowly than the big-cap techs do.
The purpose of this analysis is primarily to point out that we may need to temporarily step aside from our now-ingrained bias toward small-cap stocks and look at some of the big guys for trades instead. It doesn't mean that small stocks won't go up, only that you'll be trading more in sync with the trend of the major institutions that move the market if you focus on the big-caps for a while.
For another way to look at this concept, you may recall the
Chocolate Chip Indicator I proposed a few months ago. That was the ratio between the shares of chocolate maker
and chip giant
. The idea was that when Hershey outperforms Intel, the market is defensive and tech stocks are in retreat, and vice versa.
Chocolate Chip Indicator
The nice thing about this indicator was that it's persistent and not too noisy, which is to say it doesn't whipsaw you around. Except for a couple of exceptions (e.g., early 2002), it tends to go in one direction for a protracted length of time. In June, as you can see, the indicator topped out (in favor of Hershey) at the same place where it topped out in 1996. And it has since declined through its 50-week, or one-year, moving average. It's entirely possible that this means absolutely nothing. But if you're searching for clues about whether the recent switch in the market's preference from defensive/value stocks to large-cap growth might persist, this must be considered a potentially useful data point.
From a practical standpoint, of course, we still need to figure out what to do with this information. The most practical way to use the Chocolate Chip Indicator is to do a pair trade in which you go long Intel and short an equivalent amount of Hershey against it. Another way would be to simply buy Intel.
While that does sound like a good idea, you don't need me to recommend Intel. Instead, I would propose you consider another big-cap chipmaker,
. Its analog, mixed-signal and DSP business is good, valuation is reasonable, news flow is strong, it doesn't have a lot of enemies and the chart looks powerful, with few restrictions ahead. Its products are essentially the interface between analog signals and the digital info used in communications systems.
Major applications are in the mini hard disk drives, such as the ones in the iPod. The stock can probably be bought around the current price, with a target in the low $50s over the next six months.
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Jon Markman, writer of TheStreet.com Value Investor, is the senior investment strategist and portfolio manager at Greenbook Investment Management, a division of Greenbook Financial Services. Separately, he is publisher of StockTactics Advisor, an independent weekly investment research service. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback;
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