Broad Markets Could Use Help from the January Effect
- Posted by JC Parets
- on December 21st, 2011
The Small-Cap Russell2000 is at a pretty critical juncture relative to the Larger-Cap S&P500. These small capitalization names tend to lead the market both to the upside and the downside. A breakout above of this downtrend line in the relative chart of $IWM vs $SPY should bode well for the broad market:
This blue downtrend line represents the potential neckline of an ‘inverse head-and-shoulders’ reversal pattern. A break above this level is very important for the longer term outlook in stocks.
Tom McClellan, publisher of the McClellan Market Report, said in a recent research note to clients that when small-cap stocks lead big-cap stocks, it’s “usually a good sign for the overall market.”
The two “shoulders” are the relative lows hit in mid August and mid November, while the Oct. 3 relative low, the lowest in 11 months, is the bottom of the upside-down “head.”
The downtrend line connecting the highs between the two shoulders is the “neckline,” the break of which would confirm the bullish reversal, and indicate the bottom of the head was the starting point of a longer-term uptrend. And the Russell 2000′s recent bullish nominal performance indicates an upside relative breakout is more likely.
On the flip side, the uptrend line from the October lows up through the November lows needs to hold for anything bullish to be able to develop. There is a similar structure here to what we see in the absolute performance of the S&P500. This series of higher lows along with the lower highs of the potential neckline cannot last forever.
On a relative strength chart plotting the Russell 2000 against the S&P 500 Index, the small-cap tracker is sitting just above an uptrend line starting at the Oct. 3 relative low, and is now testing a downtrend line starting at the Aug. 30 high. A break of the uptrend line would not only point to a bout of small cap underperformance, RBC Capital Markets technical analyst Robert Sluymer said it would be “net negative” for the broader market.
When this Small-Cap vs Large Cap ratio broke support in early August, it dragged the broader markets down with it. The same leadership qualities were seen at the early October lows in this ratio as the S&P500 has been rallying ever since.
Historically speaking, small caps tend to outperform large caps going into the beginning of the year. This is what is called the January Effect. This phenomenon is not a secret, so the effect usually starts in December. So far we’ve seen a little bit of out-performance, but not enough for a breakout. Merrill’s small-cap strategist Steven DeSanctis was out with a note this week saying that, “when small-caps beat large-caps in January, the little guys average a 19% gain for the entire year and top the big guys two-thirds of the time. But when there’s been no January Effect, small-caps gain just 4% on average for the subsequent year and best large-caps only 40% of the time.”
Don’t forget about this one…
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J.C. Parets is the Founder & President of Eagle Bay Capital, LLC. He earned the Chartered Market Technician designation (CMT) and is a member of the Market Technicians Association. More
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