National Futures and Financial Weekly
Copyright 1997 by Consensus, Inc.
May 09, 1997 * * 1737 McGee, Kansas City, Mo. 64108 U.S.A. * * Up Dated Daily
BLUE-CHIP OR SMALL-CAP
Prepared by
The Kansas City Board of Trade
It's an age-old question for investors. Should I invest my money in larger,
blue-chip companies that have proven track records, or should I seek out
smaller stocks that may be riskier but also have the potential for tremendous
growth?
The arguments for each type of investment can be compelling. And with
the recent volatility in the stock market, the "Great Debate"
over blue-chip versus small-capitalization investing has escalated to new
levels. How can investors respond?
Rather than consider only the relative merits of each sector, one option
is to attempt to capitalize on the differences in the performance itself
between the blue-chip and small-cap stock sectors. This can be accomplished
using stock index futures and options contracts such as the Kansas City
Board of Trade's Mini Value Line and Value Line.
Measuring The Spread
Just as with bull and bear markets, over the course of time there have
been periods in the stock market that have tended to favor either blue-chip
or small-capitalization issues.
In the much-discussed rally of 1995 and 1996, for example, larger, blue-chip
stocks led the charge upward. The partial stock market correction experienced
in the first quarter of this year, however, has led to increased speculation
over whether that trend will continue.
The charts themselves have an interesting story to tell. One way to measure the relative performance of small-cap stocks to blue-chip issues is through stock indexes. The S&P 500 Index, for example, is widely considered a barometer of the blue-chip market, as it contains 500 larger stocks with their influence on the index weighted by capitalization. The Value Line Arithmetic Index, meanwhile, is often used as a measure of the secondary market.
While the Value Line contains around 1,650 stocks--both large and small--each
stock has an equal weight in the index regardless of its size. The result
is that in the Value Line, smaller stocks have more influence than in many
other stock indexes.
A monthly chart of the spread between the Value Line Arithmetic and the S&P 500 (Value Line minus S&P 500) shows that the Value Line fell to a low point of more than an 85-point discount to the S&P 500 in late 1990, then gradually climbed to a small premium to the S&P 500 during parts of 1994. The Value Line small-cap measure lost ground again to the blue-chip S&P 500 in 1995 and 1996. In early 1997--after falling close to the 85-point discount seen in 1990-- the Value Line recaptured some ground during a nearly 10% correction in the Dow Jones Industrial Average (see Chart 1).
Chart 1
Value Line/S&P Monthly Cash Spread
Source--CQG Inc.
<189> 1997 CQG Inc.
But since that time the Value Line has lost ground again, and at the
start of April had slipped to a new low against the S&P 500 of more
than 100 points, premium S&P.
Will the Value Line continue to set new lows relative to the S&P
500? Or has the spread neared a point at which it will reverse direction
and show the small-cap Value Line measure gaining ground on the blue-chip
S&P?
Influences
Analysts who follow the small-cap/blue-chip spread, and in particular
the Value Line/S&P 500 spread, say there are a number of market influences
to consider.
Market observers and the media in recent weeks have widely debated whether
the blue-chip dominance of recent years may be coming to an end. One factor
favoring that scenario is the relative valuation of the two sectors.
"Small-cap stocks are cheap," states the March 26 issue of
Merrill Lynch's Small Cap Perspective from Satya Pradhuman, manager of
U.S. quantitative analysis. "The current price-to-cash flow level
for small stocks is now 1.02 times that of large caps."
This appearance of small-cap issues as a bargain compared with blue-chip
stocks has fueled much of the recent talk that small-caps may be due for
a rebound. But by no means is the speculation about the small-cap/blue-chip
spread one-sided.
Indeed, many market observers have said that the liquidity and solid
performance boasted by larger companies in recent years may continue attracting
investment dollars to the blue-chip sector to the relative detriment of
small-caps. Investors in particular may be hesitant to pour money into
small-caps during a volatile market, when trading liquidity could become
especially important to nervous market players.
"Clearly, small-cap stocks do not have to rally simply because
they are cheap," Pradhuman says, adding that the factors that may
cause investors to revisit the distinction and pay attention to some of
the economic fundamentals may be two-fold.
Managers begin to compete for better returns instead of the focus on
just being fully invested.
Relative earnings gains for large-caps begin to fade.
Another factor to consider when evaluating the relative performance
of blue-chip and small-cap stocks is the outlook for different sectors
within the two universes. Joanne Hill, vice president in equity derivatives
with Goldman Sachs, notes that opportunities may exist within specific
sectors that have been hit hard during price declines.
Pradhuman cautions that "emerging growth" small-cap stocks
may have more difficulty performing in the coming market than "value"
type small-cap issues. Value stocks generally are considered to be less
expensive issues with lower expectations, while growth stocks have higher
expectations.
Yet another factor that may influence the small-cap/blue-chip spread
in coming months is the U.S. Dollar, Pradhuman says. "The significant
strength in the dollar, and a continued positive outlook for the dollar
in 1997 places pressures on highly foreign- exposed, large-cap firms."
Because of their lower foreign exposure relative to blue-chip issues,
small-cap stocks may benefit from strength in the currency relative to
large-caps (see Chart 2). Strength in the dollar in recent months has not
yet adversely impacted the large-cap sector, but eventually it should,
Pradhuman says.
Chart 2
Foreign Exposure By Stock Size
Source--Merrill Lynch Quantitative Analysis
The movement of the Dow Jones Industrial Average may be one more
influence on the small-cap/blue-chip spread.
Don Selkin, head of stock futures research with Prudential Securities,
has been following the Value Line/S&P 500 spread for several years.
He says that the trend recently seems to have been for the Value Line to
gain on the S&P when the Dow is trending lower, and for the opposite
to happen when the Dow is trending higher (see Chart 3).
Chart 3
The Value Line/S&P 500 Spread
And The Dow Jones...A Comparison
Source--MRI
Although this has not always been the case, it has been a pattern over
the last few months, Selkin said. If this trend continues, what happens
with the Value Line/S&P 500 spread in large part may be linked to the
direction of the Dow.
Based on this observation, then, investors looking at the spread may
want to consider buying Value Line and selling the S&P 500 in down
markets for the Dow, and selling Value Line and buying the S&P 500
during Dow uptrends.
"There are opportunities there," Selkin said. "It's a
matter of understanding the dynamics of the spread."
The Tools To Trade
Through a stock index futures spread trade that utilizes a small- cap
measure such as the Value Line and a blue-chip measure such as the S&P
500, investors can attempt to profit from changes in the relative performance
of the two stock sectors.
If an investor believes small-cap stocks will gain relative to blue-chip issues, he can buy Value Line or Mini Value Line futures and sell S&P 500 futures. When the Value Line gains relative to the S&P, the trade shows a profit. Conversely, an investor expecting blue-chip issues to outperform the small-cap sector can buy S&P 500 futures and sell Value Line or Mini Value Line futures.
For example, a trader believing small-cap stocks would gain on blue-chip
issues might have bought one June Value Line contract and sold one June
S&P 500 contract on March 27 at the closing spread price of 79 points,
premium S&P. At the close on April 9, the S&P 500 premium had declined
to 71.15 points. As a result, this trade would have been showing a profit
of $3,925 (79 <196> 71.15 = 7.85 x $500 = $3,925).
An investor expecting blue-chip issues to outperform the small-cap sector
might have sold one Value Line contract and bought one S&P 500 contract
on April 14 at the closing June spread price of 65.90 points, premium S&P.
At the close on April 30, the S&P premium had risen to 102.60 points.
As a result, the trade would have been showing a profit of $18,350 (102.60
<196> 65.90 = 36.70 x $500 = $18,350).
Both S&P 500 futures and Value Line futures have a value of $500
times the level of the index, while Mini Value Line futures have a value
of $100 times the index. As a result, traders wishing to use the Mini Value
Line for the small-cap side of their spread may want to consider trading
five Mini Value Line contracts for every one S&P 500 contract.
Spread trades such as those mentioned above often are considered less
risky than outright futures trades, and as a result typically have lower
margin requirements.
However, for investors wanting simply to trade broad stock market trends
rather than the more specific small-cap/blue-chip spread, Kansas City Board
of Trade Mini Value Line futures can be a useful tool.
The Mini is the only stock index futures contract that was created specifically
with the individual investor in mind. Because the Mini is only one-fifth
the size of most other contracts, it has one- fifth the tick size and often
has one of the lowest margin requirements around. As a result, smaller
investors can put down less initial margin to trade the Mini and may find
they have better staying power in volatile markets with the Mini because
of its smaller tick size.
The KCBT also offers an option on Mini Value Line futures, presenting
even more trading possibilities.
May, 1997
Kansas City Board of Trade
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