Will Small Caps Continue Outperforming Large Caps?

 

Understanding Small Cap Stocks in the Current Market

Will small caps continue outperforming large caps for a considerable time? Or have we just seen a flash in the pan? This is a question on many investors’ minds. While recent trends might suggest a resurgence of small-cap stocks, as shown by the chart below, the broader market dynamics hint at a different story.

 

I am convinced we are heading into a “winner-takes-all” economy, as Mark Hulbert (WSJ) has been suggesting since 2017.

Globalization and technology have created favorable conditions for mega companies like Apple, Amazon, and Facebook. These behemoths are leveraging their scale and technological advancements to dominate markets worldwide.

Even if globalization somehow unwinds, technology will continue to offer an advantage to tech-dominated global companies. The rapid pace of technological innovation ensures that large-cap companies with substantial resources can stay ahead of the curve, continuously improving efficiency and market reach.

Furthermore, the regulatory environment, which places undue compliance burdens on companies, clearly favors the big guy over the small guy. Large companies have the resources to navigate complex regulations, whereas smaller companies often struggle to keep up. So, I would not be surprised to see large-cap stocks outperforming their small peers for a long time. I am not saying that all small caps are doomed, but many will suffer.

The U.S. Advantage in the Global Economy

In the same vein as large companies, the USA is the country best placed to profit from the new normal. In fact, it has been taking the lead since at least 2009, as attested by the U.S. stock market performance vs its European peers. The U.S. has consistently shown resilience and earnings growth for shareholders, driven by its robust economic policies, innovation, and global influence.

I follow stock trends, but even more vital is to follow countries’ trends. Monitoring the economic health and policies of different countries can provide valuable insights into market movements and investment opportunities.

Key Takeaways for Investors

1. U.S. Market Attractiveness: Despite its challenges, the USA remains one of the most attractive destinations for capital. It is the “less dirty shirt in the laundry basket” by a long shot. I don’t buy into the thesis that Europe or Emerging markets are cheap. They are cheap for good reason: They lack earnings and have dire perspectives unless they dramatically change their economic policies.
2. U.S. Stock Indexes and Trend Following: Given that many U.S. (and world) companies are having and are likely to have a hard time in the future, stock indexes coupled with trend following to protect against the downside is my undisputable bet. What kind of trend following? Many trend-following systems are suboptimal and don’t stand scrutiny. The trend-following system must provide you with a track record spanning at least +20 years and have survived several bear markets. My trend-following systems boast a record starting as far back as 1953, so we can trade them with confidence.

3. Challenges in Stock Picking: If the future is probably going to be unkind to most stocks, most stock-pickers will suffer. What worked in the past (buy a diversified portfolio, hold it for a long time, and reap the reward) will no longer work. But don’t worry, as the saying goes, “there is always a bar full of people.” We can adjust our stock-picking strategy to meet the new normal. More on this in a future post.

For more insights into market trends and investment strategies, you can explore the detailed indicators and analysis available at The Dow Theory.

By focusing on these key areas, investors can better navigate the complex and evolving financial landscape, ensuring their portfolios are well-positioned for long-term success. The happy years of buy and hold are over.

Sincerely,

Manuel Blay

Editor of thedowtheory.com

 

Gold and Silver ETF miners (GDX & SIL) soar: Primary bull market re-confirmed on 7/16/2024

 

Gold and Silver are also in a bull market

Overview: GDX and Sil underwent a secondary reaction against the primary bull market. Confirmed higher highs by both ETFs have reconfirmed the primary bull market.

Gold and Silver are in a bull market of their own, as I explained HERE.

I see most assets going to the roof. Are savvy speculators sensing that a wave of liquidity is going to be unleashed soon?

General Remarks:

In this post, I extensively elaborate on the rationale behind employing two alternative definitions to evaluate secondary reactions.

GLD refers to the SPDR® Gold Shares (NYSEArca: GLD®). More information about GLD can be found HERE.

SLV refers to the iShares Silver Trust (NYSEArca: SLV®). More information about SLV can be found HERE.

A) Market situation if one appraises secondary reactions not bound by the three weeks and 1/3 retracement dogma.  

As I explained in this post, the primary trend was signaled as bullish on 4/3/24. Following the 5/20/24 highs, both ETFs dropped until 6/13/24 (GDX @33.15) and 7/1/24 (SIL @30.9). Such a drop qualified as a secondary reaction against the bullish trend.

Following such lows, a strong rally ensued. On 7/11/24, GDX broke above its 5/20/24 closing highs (@37.24). On 7/16/24, SIL confirmed by surpassing its 5/20/24 closing highs @35.93.

So, the confirmed breakup above the last recorded primary bull market highs implies that the secondary reaction against the bull market has been canceled, and the primary bull market has been reconfirmed.

The charts below illustrate recent price movements. The brown rectangles highlight the secondary reaction within the primary bear market. The small blue rectangles on the right show the initial days of a rally that set up both ETFs for a potential primary bear market signal, which ultimately did not occur. The blue horizontal lines indicate the last recorded primary bull market highs that needed to be surpassed to reconfirm the bull market. 

Therefore, the primary and secondary trends are now bullish.

B) Market situation if one sticks to the traditional interpretation demanding more than three weeks and 1/3 confirmed retracement to declare a secondary reaction.

In this post, I explained that the primary trend was signaled as bullish on 4/3/24.

In this instance, the long-term application of the Dow Theory coincides with the shorter-term version, so there was a secondary reaction against the primary bull market that has been successfully terminated by confirmed higher highs.

Therefore, the primary and secondary trends are now bullish.

Sincerely,

Manuel Blay

Editor of thedowtheory.com

 

Bonds at crossroads: Contradictory setups completed imply the trend is now unclear

 Once hesitation is over, the next move can be explosive.

 

Overview: The bond market is really at a crossroads. Depending on the timeframe applied, we got two contradictory potential signals. The shorter-term application of the Dow Theory, which I favor in cases like this as it is more reactive, completed the setup for a potential bear market, while the long-term one resulted in just the opposite: a setup for a potential bull market.

Such a gross divergence between the two timeframes is infrequent. When it occurs, it shows a market lacking direction. When the bond market finally makes its mind up, the final move can be explosive.

Fundamentally, the bond market is caught between two contradictory forces: deflation and a likely recession and the underlying inflationary pressures, which, notwithstanding the most rcent CPI print, have not subsided yet, as evidenced by a rising Producer Price Index.

So, let’s get started with the Dow Theory analysis.

General Remarks:

In this post, I extensively elaborate on the rationale behind employing two alternative definitions to evaluate secondary reactions.

TLT refers to the iShares 20+ Year Treasury Bond ETF. You can find more information about it here

IEF refers to the iShares 7-10 Year Treasury Bond ETF. You can find more information about it here.

TLT tracks longer-term US bonds, while IEF tracks intermediate-term US bonds. A bull market in bonds signifies lower interest rates, whereas a bear market in bonds indicates higher interest rates.

A) Market situation if one appraises secondary reactions not bound by the three weeks and 1/3 retracement dogma 

As I explained in this post, the primary trend shifted to bullish on 6/4/24.

On 7/1/24, a secondary (bearish reaction) against the primary bull market was signaled. From its 6/14/24 closing highs, TLT and IEF dropped for 10 trading days, which satisfied the time requirement for a secondary reaction. The pullback also exceeded the Volatility-Adjusted Minimum Movement (VAMM, more about it here), so the extent requirement for a secondary reaction was also met.

Following the closing lows on 7/1/24, a strong rally ensued, setting up TLT and IEF for a potential primary bear market signal.

The Table below shows all the information you need:

 

 So, now we have the following options:

1) A primary bear market would be signaled if TLT and IEF jointly break below their 7/1/24 closing lows.

2) If TLT and IEF jointly break above their 6/14/24 bull market highs, the primary bull market would be confirmed, the secondary reaction extinguished, and the setup for a bear market signal canceled. IEF, has already surpassed its 6/14/24 highs unconfirmed by TLT. The longer it takes for TLT to confirm, the more suspect the breakup.

The charts below give you a glimpse of the current situation. The red horizontal lines highlight the 7/1/24 lows whose confirmed violation would signal a new primary bear market. The blue horizontal lines highlight the 6/14/24 bull market highs. The brown rectangles show the secondary reaction, and the blue ones show the recent rally that completed the setup for a potential primary bear market.

 So, now the primary trend is bullish, and the secondary one is bearish.

B) Market situation if one sticks to the traditional interpretation demanding more than three weeks and 1/3 confirmed retracement to declare a secondary reaction.

As detailed in this post, the primary trend was signaled as bearish on 2/13/24.

In this post, I explained that a secondary (bullish) reaction against the bear market was in place.

After the secondary reaction bounce, a pullback followed, setting up TLT and IEF for a potential primary bull market signal.

The Table below shows all the information you need:

 

The charts below give you a glimpse of the current situation. The red horizontal lines highlight the 4/25/24 lows, whose confirmed violation would confirm the primary bear market. The blue horizontal lines highlight the 6/14/24 bull highs, whose breakup would signal a new bull market. The blue rectangles show the secondary reaction, and the brown ones show the recent pullback that completed the setup for a potential primary bull market. The grey rectangles highlight a pullback that did not meet the extent requirement to complete the setup for a bull signal.

Therefore, the primary trend is bearish, and the secondary one is bullish. 

Sincerely,

Manuel Blay

Editor of thedowtheory.com

Is the Dow Theory Misunderstood? The Truth Behind the Dow Transportation Weakness

 Secondary Reaction Highs (Lows): The Key to Market Confirmation

Recent weakness in the Dow Jones Transportation Average relative to the Dow Jones Industrial Average has prompted many “experts” to proclaim a bear market signal. They argue that new all-time highs by the Dow Industrials, unconfirmed by the Dow Transports, spell doom for the overall stock market.

Understanding the Dow Theory

Let’s clarify the concepts. Lack of confirmation means that one index makes a higher high (or lower low), and the other fails to break out. However, there is a common misconception about the Dow Theory. It’s often believed that if one index makes an all-time high, the other must also make an all-time high to confirm. This is not the case.

The Dow Theory, a cornerstone of stock market analysis, is based on the concept of secondary reactions. The top (or bottom) of a secondary reaction, which need not be an all-time high, is the relevant price level to be taken out. Thus, it can well happen that one index, like the Dow Industrials, makes an all-time high while the other takes out a minor high (a secondary reaction high). This counts as confirmation.

The Importance of Relevant Highs

Fixating on both indexes surpassing their all-time highs is not the right way to apply the Dow Theory. Most signals would be terribly late if we demanded “all-time highs” confirmation. Jack Schannep explains it beautifully on pages 39-41 of his book.

This post also gives a recent example of the relevant highs to focus on in seeking confirmation. While significant weakness in the Dow Transports when both the S&P 500 and Dow Industrials are making higher highs may be a yellow flag (as it was in October 2007 and December 1999), requiring all-time highs confirmation to enter the market leads to poor performance.

Thus, the lack of confirmation of a relevant high (not “all-time highs”) merely serves as a yellow light that may question the persistence of the current trend. It is NOT, as many purport, a signal showing a change in the trend.

Bullish Implications of Non-Confirmation

Furthermore, I will boldly assert that the Dow Transports’ lack of confirmation of an all-time high by the Dow Industrials is bullish. This is not just a claim, but a viewpoint supported by two studies.

The first study by Mark Hulbert  shows that the stock market performs better when the Dow Transports are lagging.

 The second study by Seth Golden shows that while the S&P 500 made a new 12-month high in the first half of the year unconfirmed by Dow Transports, it was notably higher in the second half of the year. The study confirms that “all-time” or “12-month highs” confirmations are not the proper highs to focus on when looking for confirmation.

 

Key Takeaways

Confirmation is essential when correctly applied: Focus on the highs (or lows) of secondary reactions, which in many instances are not the all-time highs. Lack of confirmation of such relative highs is a yellow flag (not a red one) with trading implications as they help avoid a sucker rally or a bear trap, as you can see in the following examples HERE and HERE, and a couple of weeks ago with Bitcoin whose breakup was not confirmed by Ethereum (a post on this non-confirmation that once again saved my skin will follow soon).

Conclusions

• When applying the principle of confirmation, identify the right highs (or lows) to be jointly taken out.
• All-time highs are not the right highs in many instances.
• Secondary reaction highs (or lows) are the right highs (or lows) to focus on in most cases.
• Lack of confirmation of a relevant high (or low) is not a Sell (or Buy) signal; it is simply a yellow flag.
• Lack of confirmation by the Dow Transports of an all-time high or even a 12-month high is actually bullish for the stock market.

Sincerely,

Manuel Blay

Editor of thedowtheory.com

 

SLV and GLD: Evaluating the Secondary Reaction and the Setup for a Potential Primary Bear Market

 

The primary trend remains bullish 

Overview: SLV and GLD (silver and gold) are in a secondary reaction, and on 6/20/24, the setup for a potential primary bear market has been completed.

The gold and silver miners ETFs (GDX and SIL) are also in a secondary reaction, but no setup for a potential primary bear market has been completed. In a future post, I will deal with the miners.

General Remarks:

In this post, I extensively elaborate on the rationale behind employing two alternative definitions to evaluate secondary reactions.

GLD refers to the SPDR® Gold Shares (NYSEArca: GLD®). More information about GLD can be found HERE.

SLV refers to the iShares Silver Trust (NYSEArca: SLV®). More information about SLV can be found HERE 

A) Market situation if one appraises secondary reactions not bound by the three weeks and 1/3 retracement dogma.  

I explained in this post that the primary trend was signaled as bullish on 4/2/24.

Following the 5/20/24 (GLD) and 5/21/24 (SLV) highs, there was a pullback until 6/7/24 (GLD) and 6/13/24 (SLV), which met the time and extent requirement for a secondary reaction. Following, the secondary reaction lows, a rally ensued until 6/20/24 that completed the setup for a potential primary bear market signal.

The table below shows the relevant data:

So, now there are two possible outcomes:

1) A primary bear market would be signaled if GLD and SLV head south and jointly break below their pullback closing lows (Step #2 in the table above).

2) If GLD and SLV extend the present rally and jointly surpass their most recent highs (Step #1), the current primary bull market would be confirmed, and the secondary reaction and the setup would be canceled.

The chart below shows the secondary reaction (Step #2, brown rectangles) and the rally starting off the 6/7/24 (GLD) and 6/13/24 (SLV) lows (Step #3, blue rectangles). The blue horizontal lines highlight the most recent highs (Step #1), whose breakup reaffirmed the primary bull market, and the red lines show the pullback lows (Step #2), whose violation would entail a new primary bull market. 

Therefore, the primary trend is bullish, and the secondary one is bearish.

B) Market situation if one sticks to the traditional interpretation demanding more than three weeks and 1/3 confirmed retracement to declare a secondary reaction.

I explained in this post that the primary trend was signaled as bullish on 4/2/24.

The most recent pullback did not last at least 15 trading days, so it did not qualify as a secondary reaction.

So, now the primary and secondary trends are bullish.

Sincerely,

Manuel Blay

Editor of thedowtheory.com

 

 

TheDowTheory.com and our recent recession alert featured by Mark Hulbert (MarketWatch)

 Understanding the Schannep Recession Indicator and Its Impact on Market Timing

 

We’re honored to have our Schannep Recession Indicator (SRI) featured in MarketWatch by Mark Hulbert on 6/14/24. We wrote a must-read article with the evocative title: “The latest unemployment report has triggered this spot-on recession indicator”

Below is the link to the MarketWatch article (likely behind a paywall):

https://www.marketwatch.com/story/the-latest-unemployment-report-has-triggered-this-spot-on-recession-indicator-08f2785d

and below is the link to a version not behind a paywall:

https://www.morningstar.com/news/marketwatch/20240614271/the-latest-unemployment-report-has-triggered-this-spot-on-recession-indicator

Below are the key highlights of Mark’s article:

1. Schannep Recession Indicator (SRI) Accuracy

The Schannep Recession Indicator has accurately identified all 12 U.S. recessions since 1946, demonstrating its reliability in predicting economic downturns.

2. Recent Recession Signal

The latest signal from the SRI was triggered on June 7, 2024, when the U.S. unemployment rate report for May showed an increase to 4.0%. This rise brought the three-month moving average to 3.9%, surpassing the threshold by 0.4 percentage points and suggesting that a recession is either underway or imminent.

3. Timeliness of SRI Signals

The SRI provides recession signals much closer to real-time compared to the National Bureau of Economic Research (NBER). Historically, the average lag between the onset of a recession and the SRI signal is just 1.58 months, offering a timely tool for economic forecasting and market decisions.

Finally, I want to remind our esteemed readers of the SRI’s Stock Market Timing Utility. Beyond predicting recessions, the Schannep Recession Indicator is another valuable tool for timing the stock market. By providing early warnings of economic downturns, investors can make more informed decisions about the right time to sell. Our Subscribers already have a plan to trade the stock market according to the new economic conditions. Do you?

Sincerely,

Manuel Blay

Editor of thedowtheory.com

 

Unlocking the Power of Trend Following and Relative Strength: A Century of Outperformance

 Reducing Drawdowns and Maximizing Returns

Trend following and relative strength works. The latest research by Gary Antonacci and Carlo Zarattini, delving into almost 100 years of data, proves conclusively that when done correctly, market timing results in significant outperformance and, more importantly, drawdown reduction. Most investors get blinded by the “outperformance” and forget that the best offense is a good defense, namely, cutting your losses short.

Below is the executive summary provided by one of its authors on LinkedIn, Gary Antonacci (emphasis added by me):

“This study delves into the profitability of a simple, low-frequency trend-following model applied to US industries using a comprehensive database of all US stocks traded between 1926 and 2024.

Over the past century, the Timing Industry portfolio achieved an average annual return of 18.5% with an annual volatility of 12.1%, resulting in a Sharpe Ratio of 1.46. This starkly contrasts the US equity market’s 9.7% return, 17.1% volatility, and 0.63 Sharpe Ratio.

In the paper’s final section, we introduce 31 sector ETFs by State Street Global Advisors and backtest the same trading methodology over the past 20 years. The ETFs successfully replicate the model’s exposure and returns.

We also assess the impact of commissions and slippage, demonstrating that the active timing strategy remains largely profitable even with high trading costs.”

Here is the link to the research article, which is worth your time:

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4857230

Sincerely,

Manuel Blay

Editor of thedowtheory.com