Soldiers and Generals

Story Highlights:

• Much of the current bull market has been dominated by small cap and value stocks, but a shift has occurred.
• Historically, large cap stocks outperform for an extended time in the later stages of a bull.
• As the shift continues, skeptics will be bothered by the fact fewer and fewer stocks are beating the market.

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During the latter stages of the 1990s bull market, a change in leadership went little noticed—small cap stocks ended their dominance, leaving the final stages of the bull market to the large caps. The same thing is happening now. The soldiers are leaving the field and the generals will now fight the war. Market volatility made its triumphant return in mid-2007, invading the broad markets. It's time to let the seasoned generals take over as the foot soldiers begin to lose ground.

Military analogies aside, correctly identifying this style shift can benefit investors. Stock markets are composed mostly of small cap stocks by number but relatively few large caps. In fact, of the universe of nearly 25,000 global stocks, only 81 are larger than the weighted average market capitalization of the MSCI World Index. Though they're the minority by count, those 81 companies are so massive by cap they pull the smaller companies up to the average. Thus, when big cap stocks lead, fewer companies will outperform the market.

Since large cap and super cap (the very largest) companies heavily influence cap-weighted indexes, look for indexes like the S&P 500 to outperform broader, small cap indexes like the Russell 2000.

That will trouble the minds of technical analysts (techies) because fewer stocks will beat the market—a situation known as negative "market breadth." Bad breadth is a problem for techies. When fewer stocks beat the market, techies conclude pain is ahead, sometimes predicting a bear market. It must be nice not to be burdened with small things like economic shifts and other fundamental factors simple chart reading ignores. It's worth noting the last time market breadth turned negative was 1998—a period riddled with investor worry and dire economic predictions, and also a period when the previous bull market proved it had much further to go. Investors who identified this style shift likely experienced terrific returns.

This trend should persist into the period ahead—it would be very unusual for a bull market to end without a moderate period of big cap dominance. The soldiers may be going AWOL, but don't worry—the generals will stand their ground for the duration of the bull market. Think big.