Small-Cap & Mid-Cap Stocks Post New Recovery Highs!

On Friday April 1st, small-cap and mid-cap stocks (not shown) posted new weekly bull market recovery highs.

When these two sectors lead the market higher, it's been a bullish omen, historically.

In addition, downside stock market risk has been below average and upside potential has been above average in similar historical climates.

"January Effect" Stats from Ned Davis Research

From 1996 through 2008, Ned Davis Research (NDR) reports that a portfolio of “January Effect” stocks (a screen of the smallest stocks with the largest price declines in the S&P 500, the MidCap 400, and the SmallCap 600) has produced an average gain of +8.6% from mid-December through the end of January.

This easily exceeds the S&P 500’s average gain of +1.5% during the same time period.

The primary reasons behind the “January Effect” are tax-loss selling and “window dressing” – or perhaps more appropriately in this case, “window undressing.”

During the early part of December, institutional investors tend to harvest tax losses from their losing stocks in order to offset some of their gains (always a good idea).

But in addition, portfolio managers like to try and look smart at the end of the year. So many managers make a habit of dumping out their worst-performing stocks in order to ensure that these losers don’t show up on year-end statements. 

Ominous Divergence Implies Caution

Charts courtesy www.StockCharts.com

The Dow Jones Industrials ($INDU), a proxy for blue chip stocks, closed at a new weekly cycle high (10,318) on Friday, November 20.

The Russell 2000, a proxy for the small-cap sector, posted a weekly close at 585, which was -5.1% below its Friday, October 16, 2009, close at 616.

That's not what we like to see. If blue chips are making new highs and small cap stocks are not, it creates a negative divergence, a non-confirmation that typically signals an end to an intermediate-term rally.

The healthiest stock market rallies occur when all of the major sectors and indices capture new highs in concert. When they don't, it typically signals that stocks will correct and/or begin moving in a sideways range.

And the most profitable and least risky rallies occur when small-cap stocks lead. That's because small-caps are considered the riskiest of the three capitalizations (large-cap, mid-cap and small-cap). And when investors are willing to bid small-cap stocks to new cycle highs, they are confident that the stock market and the economy are healthy enough to support one of the riskiest areas of the stock market. 

Other key sectors that DID NOT confirm the weekly new cycle high on Friday include the bank, brokerage, financial and semiconductor stocks.

Until these sectors and the smallcaps post new cycle highs along with the Dow Jones Industrials, the odds are high that the stock market will undergo a correction.