Chart Presentation: Large Cap, Small Cap

If you don’t know where you are going then one path is as good as another. Today we will attempt to explain where we believe the market is heading so that we can spend a bit more time appreciating the journey instead of fighting the trend.

Our view is that the issue is less whether the equity markets are going up or down and more that the markets are as skewed in one direction as they were in the other back in 2000. The chart below shows the ratio between the S&P 500 Index (SPX) and the NYSE Composite Index (NYSE). The SPX represents ‘large cap’ while the NYSE represents ‘small cap’.

To make this argument we have to have a premise and ours is that large cap versus small cap was roughly ‘in balance’ through into the end of 1994. Through the five year period between 1995 and 2000 the trend favored large cap which pushed the ratio to a peak and then through 2001 the ratio snapped back down to support.

In early 2003 the ratio began to drive lower as small cap bested large cap and for the ensuing five years the trend clearly was in favor of the smaller cap issues. Not just U.S. equities, of course, but small cap in the sense that smaller foreign equity markets outperformed the S&P 500 Index.

Another way to view the post-2000 trend is through the chart comparison at bottom of the cross rate between the euro and the yen along with the ratio between the SPX and gold futures prices.

From the peak for the SPX/NYSE ratio to the recent bottom the trend has favored small cap and foreign over large cap U.S. It has favored the euro over the yen and gold relative to the SPX.

We will not dispute the obvious- that to trade with the trend one should be long gold, the euro, small cap, and foreign- but our intention is to argue not only that the recent trend is as stretched and over done as the large cap trend was into 2000 but also that it is in the process of reversing. Our ongoing argument is that we like the U.S. dollar and large cap U.S. equities because we believe that a return to ‘neutral’ will bring the SPX/NYSE ratio up to around .18:1, the SPX/gold ratio up to around 3:1, and the euro/yen cross rate back down to around 130.

The thesis presented on today’s first page was that the equity markets are stretched as far towards small cap and small market as they were towards large cap and large market into 2000. We also argued that from 2000 through 2001 the markets corrected the excess as the SPX/NYSE ratio broke back down towards ‘neutral’ before pushing into the new trend in 2002- 2003.

At right we have worked up a comparison between the SPX/NYSE ratio and the stock priceof General Electric (GE). The argument would be that if GE was ‘too high’ into 2000 and ‘neutral’ into 2002 then it is ‘too low’ into 2008.

The GE chart is scaled in semi-log with a rising blue line representing the long-term growth trend for the stock price. The idea is that if in the process of correcting relative prices the markets exert upward pressure on the U.S. dollar and large caps then there is almost nothing more ‘U.S. and large cap’ than General Electric. If GE were to return to the old growth trend line the stockwould obviously be substantially higher than current levels.

The problem with macro arguments is that they can be perfectly correct- give or take a year or three. Below and below right we show charts of GE along with the ratio between crude oil futuresand the U.S. 30-year T-Bond futures in an attempt to tighten up the timing somewhat.

The chart below covers the time frame through the 1990 equity bear market. As we have shown many times in the past the lows for the SPX were made around the time that the ratio between crude oil and the TBonds futures reached a peak.

The current situation (chart below right) is reasonably similar. GE hit bottom at the end of the second quarter as the crude oil/TBonds ratio rose to a high and now the markets are working back in the other direction. The crude oil/TBonds ratio has declined to the 200-day e.m.a. line just as it did in early December of 2000 while GE remains well below its moving average line. In terms of ‘time’ it appears reasonable to hold a positive view on GE even if a few months have to pass before it gathers any real momentum.