Friday, January 27, 2006

When Big Caps Outpace Small Caps

Yesterday's entry looked at occasions when small caps outperform large caps on the upside and found that such a scenario leads to short-term strength in the S&P, which indeed proved to be the case on Friday. Friday's rise, however, was notable in that the gain in the S&P (SPY) was almost twice the size of the gain in the Russell 2000 Index (IWM): .93% vs. .50%.

I examined occasions in which SPY was up more than .50% on a one-day basis, and then broke down those occasions based upon the performance of IWM. In general, since January, 2003 (N = 771), there have been 202 days in which SPY has been up more than .50%. Two days later, SPY has averaged a loss of -.04% (96 up, 106 down)--weaker than the average two-day gain of .14% for the remainder of the sample (316 up, 253 down). This fits the pattern noted often in this blog: strength leads to near-term weakness and vice versa.

When SPY is up by more than .50% in a single day and outperforms IWM (N = 66), the next three days average a loss of -.08% (29 up, 37 down). When IWM outperforms the strong SPY, the next three days average a gain of .14% (85 up, 51 down). It thus appears that underperformance by IWM worsens the subnormal returns that tend to follow strong market days. When IWM outperforms SPY, strength is more likely to lead to further strength. When SPY outperforms the small caps, strength is more likely to be reversed.