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Let the trend be your friend

This article appeared in the March 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Charting analysis shows the Small Ordinaries Index has much to offer.

Photo of Gary Burton By Gary Burton, ATAA

The S&P/ASX Small Ordinaries index, used as an institutional benchmark for small-cap Australian equity portfolios (to compare portfolio returns) , is made up of companies included in the S&P/ASX 300 index but not in the S&P/ASX 100.

The index covers about 7 per cent of Australian sharemarket capitalisation and its 200 stocks range in traded price from Perpetual Limited (PPT) at around $39 per share to, at the lower end, Samson Oil and Gas (SSN) at around 3 cents.

There is a wide diversification within the index, which can lead to it having higher volatility than the broader sharemarket. The chart below shows the breakdown of constituents from each sector, with Healthcare and Industrials being the largest contributors, followed by Consumer Staples.

Breakdown of sector constituents within the S&P/ASX Small Ordinaries index

Pie chart showing breakdown of sector constituents within the S&P/ASX Small Ordinaries index

Source: ATTA

What the charts say

The chart below covers 10 years of price correlation between the Small Ordinaries and the ASX 200 index (XJO) and includes the ASX 100 (XTO) index. I have used the start of the 2003 bull market as the starting point.

Remembering the Small Ordinaries contains shares not included in the ASX 100, there are two observations that need to be made about the correlation of these benchmark indices.

History shows us that the Small Ordinaries index can outperform or underperform the broader sharemarket over the longer multi-year timeframe. More on that later.

The first observation is that the ASX 100 and the ASX 200 are closely aligned in overall performance, so much so that it is hard to distinguish any real outperformance by one or the other. Many of the companies included in these indices operate on the global stage and are drivers of our economy.

The second observation is the overall outperformance of the Small Ordinaries in times of bull markets: from 2003 to 2007 the index outperformed the broader index.

Also, note the underperformance for small-cap stocks versus large-cap stocks during times of bear markets (Editor's note: investors tend to prefer large-cap stocks with stronger balance sheets during times of high market volatility).  As the GFC bear market found it lows in early 2009, the Small Ordinaries extended its low back to the 2003 low.

The chart also shows the outperformance during 2010-2011, and more recently how small-cap stocks came back to track the ASX 200 index.

So far in 2013, the benchmark shows the Small Ordinaries has failed to make a new high from the 2011 peaks, while the broader indices have broken to four-year highs. (Editor's note: This shows large-cap stocks are outperforming small-cap ones).

Price correlation between the Small Ordinaries and ASX 200 indexes - 2004 to 2013

Line chart showing price correlation between the Small Ordinaries (XSO) and the ASX 200 index (XJO) including the ASX 100 (XTO) index

Source: ATTA

In comparison to Australia's Small Ordinaries Index, the United States-based S&P Russell 2000 index (a key barometer of US small-cap stocks) recently made a significant breakout from the ascending pattern of the past two years, as the chart below shows.

United States-based S&P Russell 2000 index - 2010 to 2013

Line chart showing United States-based S&P Russell 2000 index - 2010 to 2013

Source: ATAA

All the information provided above shows the trader or investor can outperform the broader sharemarket, by investing/trading in small-cap stocks. But first they must consider that the relative outperformance or underperformance shown in the charts leads to higher volatility within a portfolio.

At this time of the year, the reporting season can lead to significant daily price corrections, up and down, as companies release current financials and provide forward profit guidance.

Liquidity an issue

The average cost per share of equities within the Small Ordinaries space is in the $2 to $6 range, and this attracts a different type of trader/investor. With many online traders using leverage to hold positions intraday, volatility can be quite high as positions are taken and sold. This volatility attracts traders to this small-cap stocks - leveraged profits can be quite high and losses can also be significant.

This compares to the large-cap end of the market, where the prospect of dividends and index tracking can be the primary reason for holding a position.

Profiting from small-cap stocks using charting

For chartists wanting to take advantage of this potential outperformance, there are several basic practices to follow.

First, the overall direction of the stock in question. Is it trending up or down? Trends occur in many timeframes from intraday five-minute trends to multi-year tends. It is important to establish what timeframe you feel comfortable with.

When trying to eliminate the daily market noise, use a weekly timeframe to give a better overall understanding of direction. The chartist wants to observe if the stock is making new highs each week or trading sideways within a range.

The concept of price support and resistance levels are very important when gathering information before entering a position in the market, and these levels are best seen on the weekly timeframe.

For the new chartist, it is important to notice how far a stock price is ranging and be aware this can affect the overall timing decision of when to enter with a position. It is also important for the chartist to monitor volumes traded and not be attracted to shares that have little daily volume; this can make it very difficult to exit a position in the future.

This chart below shows how traders can spot when stocks break key resistance levels ($5.87 in the chart below) and a breakout in price that has developed into a current trend. This is where every good chartist, investor/trader waits for the best entry point.

How traders can spot when stocks break resistance levels

Chart showing how traders can spot when stocks break resistance levels

Source: ATTA

So write your trading plan and spend some time monitoring price action to pick up the underlying trend. With this method it helps to understand the daily movements and the time it takes to build a profitable portfolio.

The old adage that "the trend is your friend" still holds true.

In summary

The Small Ordinaries is a great place to invest and trade, but be aware the market can outperform or underperform the general market. Always find an established trend and look for a high probability entry point to buy.

Most of the time, patience is the key to avoiding large losses. Volatility is higher in Small Ordinaries stocks and many can be quite illiquid, so large positions should be avoided.

About the author

Gary Burton, a sharemarket analyst who holds the Diploma of Technical Analysis with International CFTe recognition, is a private client adviser with Wilson HTM (Sydney). He is National Vice-President of the Australian Technical Analysts Association (ATAA), and President of the Sydney ATAA Chapter. The charts and graphics used here are produced using various resources.

The ATAA is a not-for-profit association of people interested in the application of technical analysis. Many of the members operate their own SMSF, some are private traders/investors and some are professionals in the financial services industry. The ATAA has nine Chapters in Australia, based in capital cities and provincial centres.

From ASX

ASX Charting Library has a wealth of information for beginner and experienced chartists.

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