Thursday, May 11, 2006

Can Small Caps Play Catchup One More Time?

Most of my historical pattern inquiries have found that returns are subnormal following flat periods in the S&P 500 Index. For example, we are currently flat for the past three days on a closing basis. Since March 2003 (N = 802), we have had 103 days in which the S&P (SPY) has moved within a .20% range up or down during a three-day period. When this has occurred, the average change in SPY over the next three days has been .04% (53 up, 50 down) and the average change in the Russell 2000 (IWM) has been .11% (54 up, 49 down). Both are weaker than their averages for the sample overall. The S&P has averaged a three-day gain of .18% and the Russell has averaged a gain of .30%.

During our recent three-day flat period, the Russell has been down over .60%. When SPY has been flat on a three-day basis, but Russell has been down more than half a percent (N = 28), the next three days in SPY average a gain of .20% (17 up, 11 down) and the next three days in IWM average a gain of .36% (15 up, 13 down). Indeed, the last eight times we've had a flat SPY and weak IWM, the IWM has been up on seven of those occasions three days later--and six of those occasions have featured a rise of a full percent or more.

Flat periods in SPY appear to lead to underperformance when other major sectors are flat or strong. When those other sectors are weak, the returns have been normal. Recently, we've seen IWM play catchup when it has underperformed SPY in a flat market. Such a broadening of market strength would be a plus for this market. As my Weblog notes, we're seeing weakness in the new high statistics across the market sectors.