TimingCube - Changing of the guard - small caps versus large caps, strongest market segments, relative strength of market segments, strongest U.S. markets, sector rotation

Current Signal Performance as of

Signal Type	Trade Date	Index	Return since issued
		Nasdaq 100
		Russell 2000
		S&P 500

Market Update

The major indexes were able to find some stability this week, which was a welcome change from last week's precipitous drop. Stocks started by falling Monday, therefore continuing the negative action of the previous week. Tech stocks were affected the most as some of the sector's leaders such as Apple and Google posted sizable losses on the day. Helped by lower oil prices and a good earnings report from Wal-Mart, the markets reversed course Tuesday, with the Nasdaq Composite and S&P 500 respectively surging by 3.5% and 2.9% during the session. Good news on the inflation front was released Wednesday: the core Producer Price Index (PPI) for October came in flat versus an anticipated 0.2% gain. Stocks initially rallied on the news but relinquished their gains to close modestly lower on the day. The markets fell again on lighter trade the next day before closing the week on a better note by advancing Friday, with the tech sector leading once again after an analyst upgraded Hewlett-Packard and Cisco System announced that it plans to repurchase an additional $10 billion of its stock.

The Nasdaq 100 and S&P 500 respectively gained 0.70% and 0.35% on the week, while the Russell 2000 finished 0.37% lower. The Nasdaq 100 is still located below its 50-day exponential moving average (EMA), but it remains above its 200-day EMA. The S&P 500 and Russell 2000 are still situated below both their 50-day and 200-day EMAs.

For its part, our World Index Ranking portfolio lost 0.75% this week. The portfolio consists of the 5 top-ranked world indexes as of November 9, which marked the beginning of the current 4-week holding period.

Our current Buy signal remains in effect.

Trend Timing School

Changing of the guard

Many of us had become used to the Russell 2000 index, and the small cap companies it consists of, being the strongest of the U.S. markets. If historical patterns repeat, the relative strength exhibited by large cap indexes so far in 2007 might well signal the end of the party for small cap stocks.

The term "cap" in small cap and large cap is an abbreviation for "market capitalization". Market cap is a measure of the valuation, or economic size, of a public company and is equal to the share price times the number of shares outstanding. Companies are frequently grouped and analyzed by their size, and while there is no single hard and fast definition, the categories and capitalization ranges listed in the table below are representative of what is commonly used in the industry. The categories certainly benefit from definition, as most of us would not think of a billion dollar company as small.

Classification of companies by market capitalization

Micro cap	< $250 million
Small cap	from 250 million to $1 billion
Mid cap	from $1 billion to $10 billion
Large cap	> $10 billion

For the purposes of this article, we will concentrate on the mainstream small and large cap categories and ignore the more marginal micro and mid caps. We also remove the Nasdaq Composite index which, with over 3,000 companies, mixes companies of all sizes. We use the Russell 2000 as a proxy for the small cap category and the Dow Jones Industrial Average for the large caps.

Market students have observed that bull markets regularly consist of two distinct phases, each with their different characteristics. In particular, the first phase tends to be dominated by small cap stocks while the large caps take charge during the second phase. Similarly, the first phase is generally led by value stocks and the second by growth oriented issues.

The long bull market of the 1990s provides a good illustration of the distinct small cap/large cap phases. Note that we are intentionally ignoring the 1-1/2 month in the summer of 1998 which some are calling a bear market. For the purpose of our comparison, the 1990s were one uninterrupted bull market. From the market bottom in 1990 to its intermediate top in the spring of 1994, the Russell 2000 gained 128%, but in the same time span, its counterpart the large cap Dow only advanced 59%. However, from there to the top of the bull market in March 2000, the Russell added 124% but the Dow did better with 157%. In fact, counting to the Dow Jones' top in January, a couple of months earlier than the Russell 2000 top, the large cap index rose by 195%, easily eclipsing small cap gains.

Why this pattern of early small cap lead followed by late large cap strength proves symptomatic of bull markets has been analyzed extensively. The reasoning for the early phase is that small companies can respond quicker to changing market conditions but large corporations take longer to recover from the capacity reductions and downsizing they went through during the downturn. When the economy picks up speed however, larger companies benefit from their ability to obtain capital to fund the growth.

Looking at the same two indexes in the current bull market, as depicted in Chart 1 below, the small caps clearly edge the large ones every single year since the bottom of October 2002. For the first 4 years of the bull, the Russell 2000 gained over twice as much as the Dow.

Chart 1: Small caps led large caps during first 4 years of bull market

The picture has been changing since the beginning of 2007, and the small caps have started lagging as can be seen in Chart 2. They have been rising less, and during pullbacks their retreat seems sharper. That's understandable because during the prevailing credit crunch, small companies feel more pain from the rising cost of credit. Also, the weak dollar further benefits the large cap companies as many of them are exporters.

Chart 2: Large caps leading small caps in 2007

Investors draw many conclusions from the relative strength of large cap stocks versus small cap, such as believing that the bull market has years to go in its second phase. As always, we will shun such blatant predictions and let our Model be the judge of when the up trend has run its course.

The more obvious inference Trend Timers derive from all this is the value of following the strongest market segments as they take turns to lead. Should you be in doubt as to which market segments are strongest, be sure to read the FAQ below.

FAQ of the Week

Question: Which are the strongest U.S. markets?

We know the World Index Ranking as our guide to the strongest world geographies, but we often forget that it also serves to rate the various segments of the U.S. market. Of the 27 World Index Ranking indexes, 7 are U.S. based and they reflect the strength of the type of stocks in their respective index. For the portion of your assets you dedicate to the U.S. market, if any, past history favors the indexes ranked the highest.

Currently the ranking shows the large caps in the Nasdaq 100 being the strongest and the small caps in the Russell 2000 being the weakest.

Warm wishes and until next week.

The TimingCube Staff

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