by Kevin Klombies, Senior Analyst

Wednesday, August 1, 2007

Chart Presentation: Small Cap

We start out with a chart showing the ratio between the S&P 500 Index and the NYSE Composite Index. This is our measure of the relative strength of large cap versus small cap.

Through the last half of the 1990’s the large cap issues outperformed rather dramatically but from 2000 forward the pendulum has swung back in favor of the smaller issues. Our argument is that the small cap sector is now as overvalued relative to large cap as the large cap sector was at the bull market’s peak in 2000.

The trend towards strength in smaller issues goes with weakness in the Japanese yen compared to the euro. The chart at bottom shows that from 2000 into 2007 the steady rise in the euro against the yen has mirrored the relentless decline by the SPX compared to the NYSE Comp.

We mention this because the relationship seems to be working on virtually a day-to-day basis now. Below we have included the euro/yen cross rate and the SPX/NYSE Comp. ratio from September of 2006 to the present day. Notice how any strength in the yen goes directly with weakness in the NYSE Comp. The point would then be that on continued yen strength the smaller cap issues should be at greater risk than the large, well known names.




Equity/Bond Markets

The point that we were attempting to make on the first page was that in any kind of market- bull or bear- it appears that the large cap sector is ‘low’ relative to the broad universe of NYSE listed stocks. The ratio can certainly go lower- trends tend to last far longer than you expect- but over the post-1980 time frame the ratio has never been as low as it is at present.

The chart compares a World ex-USA index divided by the Dow Jones Industrial Index with the U.S. Dollar Index (DXY) futures.

The World ex-USA/DJII ratio measures the price of virtually ‘everything else’ with the large cap stock that comprise the DJII. The argument is that the dollar’s trend defines the direction of the flow of capital and as capital has moved out of the dollar it has gone with a period of marked outperformance by equities outside of the U.S.

We tend to view the currency markets as the doorways that money must pass through to go from one region to another. Money can typically move into smaller currencies for years without causing any disruption but the same is rarely true on the way out. Similar to small cap or thinly traded equities prices can rise steadily as money moves in but when the tide turns prices tend to fall rather sharply.

In any event the reality of the day is that small cap has been outperforming large cap and everything but the U.S. market has generally been outperforming the U.S. large caps. Fair enough.

The trend towards international equity markets strength can be seen through the weakness in the dollar so we should probably argue that a trend in motion will stay in motion until something changes and the change to watch for is a reversal to the upside in the dollar. We suspect that 5 1/2 years worth of capital flows away from the dollar will be compressed into a much shorter period of time once the trend finally turns back in favor of the dollar.

Just keep in mind that the dollar is still weak and the yen has been anything but strong against the euro but we just had the feeling yesterday as we watched the yen crawl back from early trading losses as the euro’s gains against the dollar faded away that perhaps we had finally reached the start of a trend change.

We have argued that large cap stocks like Wal Mart (WMT) tend to do better with a stronger U.S. dollar (which makes sense given the argument above) and with weaker energy prices. We have also commented that the share price of WMT seems to work as the inverse of the Chinese equity market these days. We suspect that this has quite a bit to do with the flow of money towards U.S. equities and the relative strength of large versus small cap.

The Shanghai SE Composite Index has moved on to new all time highs and the Australian dollar (AUD) futures have held at the 50-day e.m.a. line. Both trends- strong non-U.S. or Chinese equities and a better AUD- are negative for WMT so the basic point would be that we are still groping in the darkness for any hint of a trend change while the markets continue to mash our views into the dirt on a daily basis.