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Identify When Small, Mid, and Large Caps Are Leading

Figure 2

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Before selecting a stock in a particular sector, I generally have to decide what size company in a sector is likely to do the best. Therefore, I keep a close eye on how the small- and mid-cap stocks are doing relative to the S&P 500 (large caps).

The trend line analysis on the RS can often give some early insight as to whether the small- or mid-cap stocks are acting stronger or weaker than large caps. I often use the S&P 400 (mid caps) and S&P 600 (small caps) indices, but also analyze the iShares Russell 2000 Index (IWM), which tracks the small-cap stocks and is a very liquid ETF.

By May 2009, the relative performance, or RS line, for IWM was in a solid uptrend (line e) that stayed intact until it was broken on October 17 (line 1). This break coincided with the high made in IWM.

The small caps underperformed for the next nine weeks before the downtrend in the RS, line d, was broken the week of December 19 (line 2)

The RS was able to stay in its uptrend (line c) until June 12 before being broken (line 3). During the summer’s choppy market action, the RS formed a clear downtrend, line d, which was finally overcome in September (line 4). This was discussed on September 29 (see “Can Small Caps Break Out?”).

The small caps acted well until May 7, 2011 (line 5) when the uptrend in the RS, line e, was broken. The RS is now testing its longer-term uptrend, line e.

The A/D line on the Russell 2000 also failed to confirm the early-May highs. Taken together, this was a stronger warning signal than I recognized at the time.

Using RS Analysis to Pick Winners

As part of my regular sector analysis, I use not only the RS analysis, but also the actual performance numbers to find which of the sectors looks best. Though I have been favoring the health care sector since early this year, it came to the forefront in April, when I discussed the bullish RS analysis for both the Select Sector SPDR - Health Care (XLV) and the Select Sector SPDR - Consumer Staples (XLP). To see those charts, click here.

Once you have identified the strongest sectors, you can take it a step further by looking for the strongest industry groups within that sector.

Figure 3

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When you look at the industry groups that make up health care, one sub-group that stands out are the health care providers, which through June 13 were up 19.6% for the year versus 10.4% for the health care sector and just a 1.1% gain for the S&P 500.

The Health Care Providers have rallied sharply from the September 2010 lows, as there have only been shallow pullbacks. The RS analysis versus the S&P broke out to the upside on January 10 (point 1), as it overcame the resistance and prior highs at line c.

Ideally, you would like to pick stocks that are in the strongest industry groups in the strongest sectors. On the bottom of the chart, I have also plotted (in green) a comparison of the health care providers to the overall health care sector. In October, the health care providers broke through RS resistance (line f), indicating that this group was starting to outperform the broader sector.

By March, the providers were clearly outperforming the S&P 500, as the RS had formed a solid uptrend, line e. The RS consolidated during March and April before breaking through the resistance at line d (point 2). The RS has since surged to the upside.

One stock in the health care provider group is WellCare Health Care Plans (WCG), and the daily chart shows a nine-month trading range (line h) that was resolved to the upside in early January 2011. WCG then rallied from a low of $27.64 to a high of $32.75 before pulling back at the end of January. The correction retraced 57% of the prior rally, holding above the 61.8% retracement support.

By February 11, the RS had surpassed major resistance at line i and the OBV had also broken through the resistance at line j. These were very positive signs, and the weekly analysis confirmed the breakout.

The daily chart show a powerful rally over the past few months, as WCG is up by more than 60% in 2011, over three times greater than the health care providers Group (up 19.6%), and 59% better than the S&P 500.

NEXT: Using RS Analysis to Avoid Losers