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Tuesday, April 19th, 2011
small has been beautiful

The concept for today’s chart comes from Ned Davis Research.  This is its chart AA144, in which the value in the bottom panel is called an “equity risk premium proxy.”  It is the spread between the Moody’s Baa yield to maturity and that of the Treasury ten-year note.

In the top panel is the ratio of the Russell 2000 to the Russell 1000 — an ascending line means that the smaller stocks are outperforming.  They lagged badly in the late 1990s as the large caps got pushed to huge valuations, but small has been beautiful ever since.

One of the great things about NDR’s work is that it provides statistics on performance related to the variables pictured in the charts.  (If you want those details, you’ll have to subscribe.)  For this one, small caps do the best on a relative basis when the risk proxy is high and when it’s falling.  Big stocks generally do better when it’s low or rising.

That begs the question as to whether the indicator is low or high.  Well, that and where it’s likely to go from here and why.  Some hints may come from looking at the layers below the surface of this picture — at the somewhat unusual interest rate structure of the day and at the relative valuation of the two indexes.

How close are we to the long-awaited time when large stocks as a group look pretty again?  It may make sense to keep an eye out for what’s happening in the bond market to help you decide.  (Chart:  Bloomberg terminal.)