One Explanation For The Lackluster Performance in Small Caps

One of the big questions of 2023 has been why small cap stocks have performed so poorly relative to the rest of the market. Typically, smaller capitalized stock show outsized returns when the broad market is rallying as investors take on more risk through exposure to typically higher beta smaller stocks. One of the most popular gauges of risk appetite is the performance of the S&P 600 or Russell 2000 to the S&P 500. When these small cap indices are showing strong relative performance, it’s viewed as a positive market development and a feather in the cap of bulls.

That hasn’t been the case in 2023. While the S&P 500 is up double digits, the S&P 600 has barely climbed 5% in the first half of the year. Many traders and market commentators have observed and pointed out the strength in the mega cap stocks, primarily the likes of Apple, Google, Microsoft, Tesla and Nivida. And while these handful of names have accounted for the lion’s share of the gains in the S&P 500, it doesn’t explain why we are seeing such performance disparity from small caps.

As a technician I’m focused on the supply and demand of the market through the evaluation of price charts. I’m less concerned with “why” a market, sector, or stock did something as it relates to news events or headlines. I prefer to allow the price action to digest those headlines and analyze the resulting changes on the chart.

One chart that’s recently helped me better understand what’s taken place in the lackluster small cap relative performance is looking at market history, specifically the changes in interest rates.

The chart below shows the S&P 600 vs. the S&P 500 since 1995 with the Fed Funds Rate in the bottom panel. What I find really interesting is how it’s actually not that uncommon for small caps to underperform after the Fed has been a raising rate. In fact, each time in the last nearly thirty years, the S&P 600 underperformed when the Fed was nearing the end of their rate hike cycle. Most recently, when the Fed had two more hikes left, small caps peaked relative to large caps. Before that, the Fed had been hiking for several years and squeezed out 3 more hikes after we saw large caps take over in relative strength. Fast forward to today, the S&P 600 has struggled relative to the S&P 500 and the Fed has hiked two more times and now is believed to be in a “pause” with the door still open for them to hike some more.

What does market history tell us about when this trend in small cap under-performance ends? Well historically the Fed has started its cycle of lowering rates before we finally see some reprieve. The three examples shown above ranged from 3 cuts of 75 basis points to 2 cuts of 150 basis points that finally broke the down trend in small vs. large caps. While this is a very small sample size, it does paint a clearer picture and give some degree of explanation to why we haven’t seen stronger performance in small caps this year.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.

Launching The Thrasher Analytics Substack

It’s been a busy couple of weeks with the CMT Association Symposium in New York where I received the Charles H. Dow Award for my paper, 5% Canary, followed by a family vacation, and then attending the NAAIM Conference in Arizona to accept the Founders Award and present on the topic of the paper.

Now that I’m back, I’ve decided to begin posting to Substack some of the content that I share on Twitter. Specifically, the few charts I post publicly from the weekly Thrasher Analytics letter that’s sent to subscribers. For those that are less active on Twitter (as I’ve somewhat become) and are curious what type of analysis and charts are shared in my weekly letter, this will provide a small glimpse into what subscribers receive each week. Posts to the Substack will be shared 24 to 48 hours after subscribers receive the letter.

To subscribe to the Thrasher Analytics Substack, Go Here.

To learn more and subscribe to Thrasher Analytics, Go Here.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.

Winning The Charles H. Dow Award For The Second Time

I’m extremely honored to share that I’ve won the Charles H. Dow Award for my paper, The 5% Canary. This is the second time a paper I’ve written has been selected to receive the Dow Award by the CMT Assocation. The 5% Canary focuses on when equity indices decline from 52-week highs and the duration of time it takes to reach a 5% drawdown. When these declines happen quickly the market has shown a continued bearish bias while when the declines are more protracted in duration, the market has often shown strength soon after. Having read about a math problem proposed by Johann Bernoulli in 1696 that sought to discover what type of path an object would need to travel in to go between two points in the quickest amount of time. Inspired by the answer to Bernoulli’s problem, I applied the concept to the financial markets and led to my research that resulted in the conclusions I wrote about in this paper.

About the Charles H. Dow Award from the CMT Assocation:
In 1994 the CMT Association established the Charles H. Dow award to highlight outstanding research in technical analysis. The Award has received over 160 submissions and recognized 26 papers for their excellence. Of the more than two dozen authors/coauthors who have won, eight have gone on to publish books based on their submissions to the Charles H. Dow Award. Winners have presented at the CMT Association’s Annual Symposium, local chapter meetings, and participated in CMT Association podcasts and/or educational web-series.

I am honored to receive this award for the second time, and I am happy to now be able to share my paper publicly.

To read the paper please visit this link: The 5% Canary (Andrew Thrasher)

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.

Bearish and Bullish Momentum Ranges

Momentum indicators are widely used by most technicians. There’s a wide variety of applications of momentum. Some look at high-low ranges, closing values only, various lookback periods, smoothed values with the inclusion of moving averages. How they are used also varies. Some traders look for extremes in momentum as signs for potential mean-reversion. Others seek divergences, such as with momentum making a lower-high as price makes a high-high. However, one topic regarding momentum indicators that doesn’t get as much attention are ranges. The range that a momentum indicator – and for this post’s purposes we’ll be using the 14-period Relative Strength Index (RSI) – can tell us a lot about what’s going on in the market’s price action.

Ranges can be viewed in various timeframes; my focus today is looking at the weekly chart of the S&P 500 and the 14-week RSI. The focus isn’t on the “overbought” or “oversold” levels of 70 and 30. Instead, we’re more interested in when RSI rises above 60 or falls below 40. Strong momentum often begets continued strength, so when we see momentum staying elevated (outside of extreme levels like getting north of 80 back in January 2018), that’s historically been bullish for price continuing to rise. The opposite has also been true, when RSI is weak, hitting levels under 40, then price is deemed to be in a bearish range and price activity often finds itself in a down trend.

Below is an example using the weekly chart of the S&P 500 since 2000. Let’s unpack what can be learned from this chart:

  1. First let’s look at the major bear markets that began in 2000 and 2007. Notice as those down trends developed, the weekly RSI was unable to produce a reading above 60. It wasn’t until the down trends had ended and price began to show strength that we got the first break above 60.
  2. This doesn’t just apply to major bear markets. When RSI goes from under 40 to above 60, historically price action has appreciated further. I’ve plotted green arrows when this has occurred. Each move above 60 after being under 40, the shift from a possible bearish range to a potential new bullish range has been a positive sign for the Index.

We can take this concept of ranges a step further and look at a more systematic approach to identifying when the S&P 500 is in a bullish or bearish range based on its 14-week RSI. The chart below goes back to 1980 and turns green when the RSI has spent 3 of the last 4 weeks above 60 and turns red when the opposite occurs, spending 3 of the last 4 weeks under 40. To assist in identifying the ranges we’re looking for when it’s been above or below the noted levels for at least a few weeks rather than just a single week that pierces the threshold and immediately moves away (as we saw in August 2004 and June 2010).

Looking at the far right of the chart, we can see this metric is one that bulls still have left unchecked with regards to the rebound in equities that began in October 2022. Currently the 14-week RSI still hasn’t been able to breach 60 which leaves us still in a bearish range.

By taking a systematic approach to identifying the ranges of momentum, we can run a simple back test to see how the market has performed when in these ranges. The chart below shows difference in performance of when the market is in bullish range (orange line) vs. when in a bearish range (blue line). This isn’t intended to be a trading signal but to provide insight into the condition of the market, based on whether the range momentum finds itself in. And of course… It’s important to note this is not a recommendation to buy or sell and past performance is not indicative of future returns.

By taking a step back and looking at longer-term charts such as the weekly chart examples used above, we can evaluate the ranges of momentum and work towards identifying what kind of market environment we may find ourselves in. The analyst can also play around with different thresholds. 60/40 are the ones I used today but are by no means the only options available and other technicians may find other thresholds for range identification useful.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.

Speaking At The CFA Society Indianapolis Forecast Symposium

Happy New Year!

I have the great honor to be one of two speakers at the upcoming CFA Society of Indianapolis Forecast Symposium later this month. The event will be taking place at the Gainbridge Fieldhouse in downtown Indianapolis, the home of the Indianapolis Pacers.

Ciff Asness of AQR will be the keynote speaker and I can’t wait to hear what he has to say as we move into the new year! I’ll be discussing my paper that won the Charles Dow Award, Forecasting a Volatility Tsunami as well as how I use technical analysis as a Portfolio Manager.

If you’d like to attend, please go to the event page to purchase tickets here:
3rd Annual CFA Society Indianapolis Forecast Symposium Tickets, Tue, Jan 24, 2023 at 4:30 PM | Eventbrite

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.