Fourth Time is a Charm?

One of the charts I keep my eye on is the ratio of the Russell 2000 versus the Russell 1000 - Small caps versus large caps. Generally speaking when the former is outperforming the latter in an extreme fashion, speculation levels are running near overbought. When the latter is outperforming the former, then speculation is relatively low and buyers are focusing on relatively conservative large cap stocks. Over the past 5 years, this chart has given three sell signals that has been very reliable in arguing for a short term market top. And now with the S&P closing 2010 highs today and the ratio once again sitting in overbought territory (as it pierces the lines). However, there is one distinct difference between this move and the previous three - the ratio is not overbought according to the oscillator. further, the previous signal from the spring preceding the flash crash, never broke through the 20 period moving average. In short, the ratio never really fully unwound the overbought state.

I am left wondering what this means. Does the ratio breakout to a higher high pushing speculation levels off the chart or does it move to higher levels but reverse violently sending the markets to a deep oversold state that it probably should have gone in the summer? I could honestly make the case both ways. The bullish story argues that the ratio find firm support and a higher low arguing for a higher high. The bearish case is basically the fact that we had the higher low and did not fully correct the excessive speculation that existed in the spring.  History tells us that markets which do not have healthy corrections, have major corrections. We saw this in 2006/2007 with the markets moving straight up in the fall into Feb 2007 and crashing with the Shanghai comp. We saw such in the spring of this year and the flash crash and three months of pain that followed.

So as we proceed through the end of the month, I will be watching two things closely. First, what the S&P does with current levels. Second, what the Ratio here does; will it breakout to higher levels and hold; will it fail to make higher levels and reverse lower; or will it breakout to higher levels, move to overbought and then correct? I will be looking for clues in the weeks/months ahead.

Related articles

• Large-Cap Tech Stocks May Be Running Too Fast (dailyfinance.com)
• Analysis: Investors pine for big caps as smallcaps outperform (reuters.com)
• Buffett's Favorite Valuation Metric Says Stocks Are Expensive (businessinsider.com)
• Jeff Saut: The Rally Is CLEARLY Getting Tired And Overbought Now (businessinsider.com)