Monday, March 15, 2010

Risk Appetite and the Relative Performance of Small Cap Stocks

Here we can see an important dynamic of the recent bull move in stocks: smaller cap issues (IWM; yellow line) have significantly outperformed larger cap stocks since the February bottom. That strength has also been reflected in consistently positive NYSE TICK readings, which capture the upticking within the broad list of stocks.

The relative strength of smaller cap issues suggests a healthy risk appetite among traders and investors, who gravitate toward more volatile and entrepreneurial companies when they anticipate economic growth and toward larger, more stable blue chip companies when they fear economic contraction. In the current economic scenario, these traders and investors are clearly anticipating further growth.

Even within the S&P 500 universe, we see outperformance of smaller cap issues relative to larger ones. The unweighted S&P 500 index (RSP; pink line) has outperformed the standard, cap-weighted S&P 500 index (SPY; blue line) since the February lows. Once again, this reflects a relative degree of risk appetite among stock traders.

As long as NYSE TICK statistics look strong, the advance-decline line remains healthy, and small caps are performing well relative to large caps, it is likely that the bull market will find continued support. It's when those patterns change that we're most likely to see a meaningful market correction.