Yesterday on X, the platform formerly known as Twitter, I saw a ton of “gurus” (largely basement traders who use squiggles to buy or sell without knowing if their analysis has predictive power) argue that “we are close to a major low,” because while large-cap averages were weak, small-caps were slightly positive. “It’s a sign of risk-on.” “It’s a leading indicator.” “The low is in.”
I love when people say things without ever actually testing if what they are saying is predictive.
Here are the facts.
Major lows are marked by panic in all equities. As stocks begin to rebound, there’s initial skepticism because of just how large and sharp the decline was. So what do traders and investors do? They speculate. But they do so with a preference toward liquidity just in case the low is not in. That means the first thing they typically try to catch a falling knife on is large-caps. Why? Because large-cap stocks have high liquidity and tight bid-ask spreads, allowing those speculators to get in — and potentially out — quickly should things begin to turn south again.
As the trend asserts and you move further from the low, confidence grows. As confidence grows, investors and traders feel more comfortable going into higher-risk investments, which typically have much less volume and dollar liquidity in the public markets. That’s when they position into small-caps. They don’t do it in the initial phases because of skepticism. They do it when the skepticism fades.
No doubt small-caps are oversold on a relative basis to large-caps, as I’ve written about repeatedly here on InvestorPlace. But the reality is that it can outperform large-caps on a relative basis as both large-caps and small-caps decline in price together in absolute terms. That’s what makes this juncture a trap in my view.
The Bottom Line
Of course, it’s more than that. I’ve done backtests on small-caps and the reality is they aren’t a leading indicator of markets more generally. You know what are leading indicators to markets I can prove from a backtesting perspective? The parts of the market that are now firmly giving a warning sign.
I maintain my view that this is a very high-risk juncture short-term. Treasurys are clearly acting more like a risk-off safe-haven trade with how equities behaved this week. I see way too many people trying to call a short-term bottom in stocks, not knowing what history shows is real and isn’t, and not understanding conditions.
That’s typically how market work. They suck everyone in just before everyone gets sucker-punched.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
