Education & Information
Large Cap vs. Small Cap Indicator
You will find that there are trends in the market in which large caps will out perform small caps and vice versa. These trends tend to be long term, lasting about three years on average until there is a change in leadership. The Large Cap vs. Small Cap Indicator helps you focus on the leader and avoid the lagging asset class. It measures the strength of the S&P 500, an index of 500 of the larger capitalized stocks, relative to the Russell 2000, an index of 2000 small capitalized stocks.
On a weekly basis, the closing value of the Russell 2000 is subtracted from the closing value of the S&P 500. That number is then divided by the S&P 500 closing value to calculate a percentage. For example, the closing price for the S&P 500 on December 31, 1999 was 1455.22 and the Russell 2000 closed that week at 504.75. The calculation would be 1455.22 – 504.75 = 950.47. That is the difference between the two indices. We would then divide the 950.47 by 1455.22 resulting in .6531 or 65.31%. Finally, this percentage is charted on a bullish percent chart (click here to see chart).
When it is in a column of Xs and moving up, the S&P is performing better than the Russell 2000. When in a column of Os and declining, the Russell 2000 is performing better. A little history of this chart shows that a reversal up into a column of Xs from the 45% level is the time to focus your investments on large caps as they are likely to outperform. A reversal down in a column of Os from above 60% is the time to focus your investments on small caps. The most recent signal this indicator gave was with the week ending December 31, 1999. The chart peaked at the highest level ever in March 1999 at 69%. This chart does not move every week. In fact, there were no entries made to the chart from March 1999 until December 1999. With the closing prices of both indices the last week of December 1999, it reversed down to 66% and that is enough to cause a reversal down in to a column of Os. That reversal indicated that the long stretch of large caps out performing the small caps was ending and small caps were to take over the leadership in the market.
That was a timely sell signal for large caps and we wrote about this change we saw taking place in our newsletter dated January 14, 2000. In that letter we said, “The Large Cap vs. Small Cap bullish percent chart reversed down into a column of Os indicating that small caps are beginning to out perform the large companies. I believe this is a change of major proportions and it should not be taken lightly.” (click here to see the full newsletter)
This indicator can be helpful in both advancing and declining markets. Our objective when using these indicators is to help us manage portfolios on a risk adjusted basis. Shortly after that buy signal for small caps and sell signal for large caps at the end of 1999 the markets began an overall decline. Since that time the large cap stocks (S&P 500 Index) declined by 26.67% while small cap stocks (Russell 2000 Index) declined by only 3.42% (through May 31, 2002). Although the small caps declined during this stretch, it did not drop nearly as much as the larger issues.
As you can see by reviewing the chart, this indicator does not move frequently. In fact, this entire chart covers 15 years of history of this indicator. The signals given by this indicator last for several years before a new signal is shown. There have only been 4 major signals in the 15 year period. Below is a review of the four signals.
Large Cap buy signal - October, 1988 - This chart reversed up in a column of Xs indicating that large caps will outperform in October, 1988 noted by the A in bold print. This trend continued until February, 1991, lasting for 28 months. During that time, the S&P advanced 20.9% while the Russell 2000 declined 2.3%. By following this indicator, you could have avoided exposure to the small cap asset class that declined and focused on the large caps that advanced.
Small Cap buy signal - February, 1991 - It reversed down into a column of Os in February, 1991 (noted by the 2 in bold print) indicating that small caps would start to outperform. That trend lasted for 41 months, until July 1994. During that time the Russell 2000 advanced 67.2% while the S&P 500 advanced only 32.1%. Although both advanced, it paid to focus on the large caps as they provided more than twice the returns than small caps did during this time fame.
Large Cap buy signal - July, 1994 - The chart reversed up from below 45% in July, 1994 (noted by the 7 in bold print) indicating that Large caps would provide the best gains in coming months or years. That trend continued for 65 months until the reversal down in December 1999. During that time the S&P advanced a whopping 225.12% while the Russell 2000 did less than half as well, up 107.43%. Not a bad return by any stretch, but the Large Caps blew them away.
Small Cap buy signal - December 1999 - Just when the media had everybody convinced that the only way to make money is to buy and hold the large caps this indicator changed showing that small caps would take over the lead for the next few years. This buy signal for small caps remains as of this writing (May 31, 2002) lasting for 29 months so far. During this time, the large cap stocks declined by 26.67% while small cap stocks declined by only 3.42%. Although the small caps have declined during this stretch, it did not drop nearly as much as the larger issues. You could have almost entirely avoided the bear market of the 2000’s by following this indicator and focusing on small caps for the last 29 months.
In the future, there will surely be major turning points in market leadership between the large cap and small cap asset classes. Using this indicator will help guide your tactical asset allocation decisions helping you reduce risk to the class that will under perform and focus on the class that will provide better opportunity to profit.
Large Cap vs. Small Cap Chart
