With markets staging an incredible start to the year — not just in the U.S., but globally — the natural question most people have is whether the rally is real and will continue, or if it’s simply a countertrend in a broad bear market.
I sympathize with investors who are left scratching their heads over what to do now that equities have rallied substantially. The anxiety of whether to chase performance now or wait for a pullback is likely higher today than at any point in recent market history.
However, I would argue that looking at the S&P 500 or Dow Jones Industrial Average is not the way to think about investing. What ultimately matters for markets is risk sentiment. If animal spirits are returning to markets, they likely will persist independent of how fast stocks have gone up. Market conditions dictate behavior more so than anything else from a macro standpoint, and I think the conditions for further advances still are favorable for the bulls.
One way of getting a sense of risk sentiment is to look at the iShares Russell 2000 Index ETF (NYSE:IWM) relative to the iShares S&P 500 Index ETF (NYSE:IVV). Check out the price ratio.
Click to EnlargeAs a reminder, a rising price ratio means the numerator (IWM) is outperforming (up more/down less) the denominator (IVV).
The old adage that the “trend is your friend” is as true now as it has ever been, particularly when analyzing relative price ratios.
The idea behind looking at small-cap stocks relative to large-cap stocks is to get a sense of what market participants are positioning into. Small-cap stocks (the Russell 2000) tend to be less liquid and have higher sensitivity to market movement than large-cap, low-beta stocks (the S&P 500). When investors are bullish and their confidence is about the state of financial markets and economy is growing, they tend to push small-cap stocks higher at a faster clip. The strength in smaller companies is itself an indicator of bullishness. Notice the substantial strength in the ratio that began in 2012 after having bottomed at the October lows of 2011 right before the “Fall Melt-Up” occurred.
The main point, though, is that the trend for now remains intact, and suggests that further gains still could come to markets, even after the strong start to the year. Risk-on seems to be the environment markets want.
The author, Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing. The commentary does not constitute individualized advice. The opinions herein are not personalized recommendations to buy, sell or hold securities.
