Thursday, April 26, 2007

Large Cap vs Small Cap

This chart shows the Russell 2000 Index(Small-Cap)versus the S&P100 Index(Large-Cap). The bottom pane shows the spread(Russell2000/S&P100)as a read line. Lately large cap stocks have been outperforming smaller cap stocks(far right blue line). This could be because small caps have had a run and now it is rotation time and the larger caps are a better value. It could also mean some other things. When investing in large cap stocks, the required time to gather research is quite easier, because so much more information is available. There dozens of analysts who cover just about every stock in the S&P 100. On the flip side, small cap stocks take more work in researching. They are smaller companies and are usually not as widely followed. They are often newer companies and not as established as the cap stocks.

Another point worth considering is what happens when a fund manager wants or needs to invest large amounts of capital in the market. With smaller capitalized issues, it is very hard to just click a button and buy 100k shares of some of these issues. It is far easier to put large amounts of money into large cap stocks. They have much greater liquidity. This also works on the other side of the coin. If a fund manager needs to raise capital, it is far easier to sell a 100k shares of GE than to work an order over a week to sell some smaller cap issues.

Is the large cap rally going on now a result of the expectations that interest rates are going to be going down later this year? If rates go down, it could create more liquidity and with investments in real estate not looking great right now, the expectations could be that this easy-to-get money will go into the stock market. It seems there is always some asset class that is getting inflated by sizable pools of capital that move around. The section of the chart above marked "A" marks the Asian crisis in the fall of 1998. This crisis was met with a Federal Reserve and other central banks adding huge liquidity to the global system to avoid a panic. What happened was that this easy to get money was plowed into large cap stocks. This continued on until after the phantom Y2k scare was over, when every computer was thought to be capable of shutting down. It was not until after 2000 that liquidity would start to be contracted. The Fed had to put some of its bullets back into the gun. Stocks got crushed and money rotated into the Real Estate market.

The section of the chart marked "B", is the sell off after the market top in 2000. Large cap stocks took the hit as redemptions in mutual funds and corporate corruption cases caused uncertainty and people were forced to sell where they could; large cap stocks.

The S&P 100 looks like it is going to try to make a move to its old high, if it can gain support at this 61.8% retracement level. It is an important area to watch.

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