Wednesday, January 24, 2024

Dow Theory Update for January 24: Navigating the New Normal: Why Small-Cap Stocks Lag Behind the S&P 500

The Small-Cap Conundrum: Is the Glory Days of Outperformance Over?

Over the past five years, small-cap stocks have consistently underperformed the S&P 500, as illustrated in the chart below. 

 


While occasional bursts of outperformance may occur, I'm skeptical that small caps will revert to their historical pattern of consistently outshining large caps. The landscape has shifted, and unless we see a significant change in the globalized economy and a relaxation of regulatory constraints, it seems the dominance of large caps is entrenched.

A consequence of this shift is the diminishing share of overall earnings that small-cap stocks are receiving. In our increasingly winner-takes-all economy, the advantage tilts toward large-cap stocks, thanks to the powerful "network effects" from which larger companies stand to gain the most. If this trend persists, my anticipation is that small caps will find themselves vying for a shrinking slice of the pie, while their larger counterparts continue to flourish.

Mark Hulbert's article, aptly titled "Why the S&P 500 is destined to keep crushing the Russell 2000," provides compelling evidence supporting this trend. Additionally, I'm convinced that the expanding regulatory environment disproportionately affects small caps, creating an uneven playing field that gives larger companies an unfair advantage. It's no surprise that small caps boast a lower Price-to-Earnings Ratio (PER), but the underlying issue is that substantial challenges faced by smaller companies justify this seemingly cheap valuation.

What to do?

By following trends and focusing on sectors with strong relative strength, we strategically sidestep the underperformers and align ourselves with the winners. In our Letter, we set aside pride of opinion, attentively listening to the cues conveyed by market action. Subscribing to our Newsletter dramatically enhances your odds of becoming a successful investor. Join us on the path to smart investing!

Sincerely,

Manuel Blay

Editor of thedowtheory.com

 

 

 

 

Tuesday, January 23, 2024

Dow Theory Update for January 23: How a Falling ERP Isn't the Bearish Sign You Thought It Was

Dispelling another investment myth

Is a falling Equity/Risk Premium (ERP) bearish for stocks? No, it isn’t. Jay Kaeppel (HERE) debunks another investment fallacy by showing that a falling ERP does not influence the stock market. So, a relatively low yield of stocks vs. bonds has zero predictive power of future performance. Actually, as shown in the screenshot below, the stock market is up an average 9.57% after the ERP crossed below 0.5 (which means stocks "expensive" relative to bonds). 


In trend following, our trade horizon seldom exceeds a year, making most fundamental measures, especially the equity risk premium, counterproductive to our performance. Paying too much attention to them can be detrimental to our portfolios. Our Composite Indicator, which is a trend-following indicator based on the Dow Theory for the 21st Century and the BlayTiming Indicator, made over +18% in 2023 by ignoring a persistently high ERP during 2023. 

The moral of the story: Focus on price action, and don’t let yourself be fooled by the noise.

Sincerely,

Manuel Blay

Editor of thedowtheory.com