What I'm Looking For

I'm looking for a tell that this leg of the rally is done, and a timeout is likely to ensue.

My best guess is to watch the compression of returns between small-mid caps and large caps. When you see the SMID caps treading water and the large caps playing catch-up (especially if it is in a hurry), then there is a good chance a reversal is not that far away. Panicked buying is always a good sign.

The rationale for this is the fact that the SMIDs have led this rally from the beginning (SMID is up 17% YTD v 9% for the S&P 500 - a carryover from 2009). When their leadership begins to falter, then that is a sign the market is losing steam, and a more cautious tone is taking hold.

Within the SMIDs, consumer discretionary and financials have been the leaders this year (up 30% and 18% respectively). So watch them closely for an early sign of slippage.

Been Losing Ground In Last Few Days

We've had a huge run in the SMID cap portfolios this year, in spite of being long the market all year.

Relative Performance of US Small-Mid Cap BRI vs. S&P 1000 as of 4/28/09
QTD 1.46%
YTD 9.05%
TTM 2.73%
2Yr 4.35%
3Yr 3.81%

But I have given a little back lately in the wake of the market continuing to rise and am losing ground again today (I began selling into the rally when the Standard and Poors 500 went through 850, and am of the mind to continue selling into any rally and put on inverse ETFs, especially if it goes crazy).

The market has absorbed the swine flu fears and is powering higher with tremendous momentum behind it. We've experienced a sea-change in sentiment and there is a sense that those on the sidelines and those short the market are getting squeezed back into it. As such it has the potential to see explosive action on the upside.

Article by Willem Buiter on his FT blog encapsulates my thoughts and concerns (http://blogs.ft.com/maverecon/2009/04/green-shoots-grounds-for-cautious-pessimism/) and indicates where I am at.

Tightly Coupled System

This is an anecdotal observation. It seems to me that the SMID cap marketplace has changed from a reasonably tightly coupled system to a much more free-wheeling one (I know I am not using these terms in a technically correct sense, but they convey the idea of what I am trying to get across). This relates to the observation that in the old days, ie. prior to August 2007, the daily relative performance of the SMID cap strategy vs the Standard & Poors 1000 was pretty stable and never diverged by much more than 20-30bp, even on a big day. This was the general norm, except that you would always go into earnings season hoping that the skew would be one of upside surprises (vs downside surprises). In contrast, it seems to me that daily relative performance gyrations of +/- 50-100bp are not uncommon now and this seems to be the new normal (at least in my space).