FRONT-RUNNING THE RISK AVERSE

Ok, the title might be a bit ambitious. though it holds some truth as we delve deeper into this post. One of the most popular and quite simple risk measures within equities is the differences in performance between large-caps and small-caps. That ratio is still heading towards the upper right side of the chart in quick fashion.

Explained in short, speculators will stick to the "safe" and big companies when the market looks shaky. On the contrary small-caps are favored when market conditions are optimal as these are companies that are frequently in the early stages of growth and give speculators the possibility of higher returns. Small-caps stocks are thus also the ones that get hit the hardest during times of turmoil. It's why the Russell 2000 index hasn't really recovered much since the November 2021 top.

Take a look at the ratio between the S&P500 and the Russell 2000 below. It only recently broke above values not seen since the end of 2001 after coming out of quite the bottoming process. This suggests that speculators are cautious and prefer safer investments. Money flowing into large/mega-caps is a sign that "defensive" assets are being valued a lot more right now. Historically, during every bear market since 1984, large-cap stocks have outperformed their smaller counterparts by an average difference of ten percent.

Now, do we actually agree with what the ratio tells us? A difficult question. We have to look under the hood to really understand the situation. There's this phenomenon called the 'January effect'. This is a perceived seasonal increase in stock prices during the month of January. This rally usually happens because more people start buying stocks, duh....It happens after the prices drop in December, which is when investors often sell their stocks to offset their capital gains for tax purposes, which is the case in the US.

Take a look at the seasonality chart of the ratio between large-caps and small-caps below, taken from stocktradersalmanac.com. For most of the year, large-caps do better than the little guys. However, early November...the little guys start hitting the gym all the way until around the end of May where they go into hibernation again. Small-caps are a big beneficiary of the January effect.

See, now the story changes a little from what we wrote about in the beginning. That sudden break above in the large-cap versus small-cap ratio might be an overextension. There's a lot more to this than what we've discussed here but it serves as a solid starting point to stimulate thoughts on the next steps that we could take for our investment or trading decisions.

What's your take on this? Should we follow the current trend suggested by the ratio, or should we consider the seasonal patterns and speculate on a potential reversal in the large-cap vs. small-cap ratio? Share your insights in the comments or through our contact form, we're eager to hear your perspective.