What's wrong with the Dow 30 stocks?

Large stocks are badly lagging smaller, riskier stocks in the rally out of February's low.

By Anthony Mirhaydari Mar 8, 2010 10:21PM

MirhaydariSmall stocks, which have been leading the broad market out of February's low, have launched impressively to new highs. Over the last 21 days, the Russell 2000 small cap index has gained a whopping 13.1%, compared with a 5.5% gain in the Dow Jones Industrial Average. This has been the longest and largest string of gains for the small caps since the awesome July 2009 rally.

 

So this is great news, right? Well, it depends. In the early stages of an upswing, such a performance disparity between smaller, riskier stocks and larger stocks is normally a positive indication of rising risk appetites among investors, and thus presages further gains.

 

However, there's a catch. The fact that large stocks like the 30 name brand stocks in the Dow Jones Industrial Average including ExxonMobil (XOM) and General Electric (GE) are lagging so badly can be a cause for concern as the current rally matures.

 

I don't want to sound the alarm -- the next few days are historically very good ones for stocks. Just think of this discussion as a little "service needed" indicator light on your dashboard. Nothing serious, but it merits attention.

 

To use another analogy, every market advance can be thought of in terms of warfare. First, the special ops teams drop in behind enemy lines and may engage with light arms to judge resistance. Then the generals send in the infantry to trudge ahead and surge across battlements with brute force.

 

The scouts, in our case, are small caps and consumer stocks that have been on a tear over the last few weeks. But if the rest of the market don't close the performance gap and join the fight, soon the bears will close ranks around the small caps, slaughter them and end the stock rally.

 

Small vs. Large

 

I see two ways this can play out. The late-December analog (green circles in chart above) would have large caps perk up and pull the market higher -- albeit at a slower and less exciting pace. We could expect another few percentage points of upside for the major indices before shares moved lower again. If the mid-September, August and June analogs instead hold true (blue circles), then we should expect a sharper transition from advance to decline as large caps fail to assert themselves.

 

In either case, the upswing out of the February low may be much closer to its end than its beginning, at least from a traders' perspective. The performance disparity between small and large cap stocks is reaching extremes. A number of technical short-term indicators are topping out after reaching overbought territory. And although the beginning and middle of March are historically periods of strong seasonal strength for stocks, the end of March can be difficult.

 

With all of this in mind, I am increasingly on the lookout for opportunities on the short side and have added the Direxion 3x Daily Small Cap Bear ETF (TZA) to my portfolio at Wall Street Survivor.

 

You can watch me trade during the day at Wall Street Survivor.

 

Disclosure: The author does not own or control a position in any of the funds or companies mentioned.

 

Anthony Mirhaydari is a researcher for the Trader's Advantage investment newsletter. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.

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