Market ratios that spell trouble

NEW YORK (MarketWatch) � Fundamental analysts love ratios. Earnings per share, price to book, profit margin � you name it, they�ve got it.

But technical analysts like ratios, too, and some of them are telling us a few things about the market that might make for a rough summer.

TRADING STRATEGIES: April
Spring cleaning

With a change of seasons, comes a chance to do a little portfolio maintenance. Do you sell in April and go away? Buy and hold? Move into seasonal stocks? Let MarketWatch�s experts help you freshen your investments.

� Market ratios that spell trouble
� Balancing your portfolio for spring
� Two financial stocks to sell and two to buy
� 11 stocks to throw out during spring cleaning
� A not-so-pleasant spring for Europe
� Bringing some spring air into your portfolio
� Should you sell in April?
� Clean up with perpetual dividend raisers
� A mutual fund review that doesn�t hurt
� There�s more to tech than Apple
� Johnson roots for an April pullback
� Hammers: March boom to April bust �

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Most investors understand that most, although certainly not all, healthy markets enjoy strong participation by the higher reward/ higher risk groups. These included technology and small capitalization stocks. After all, these are the areas where innovation is born and the stakes are high. And as much as their ads tell us that soup is good for us, a fully mature stock such as Campbell�s Soup Co. CPB �is not going to lead a bull market.

Technology stocks, as well as consumer-oriented stocks where marketing gurus can create �buzz,� have garnered a good deal of investor attention this year. So have financial stocks but they have not been critical to market performance since the financial crisis of 2008.

Chart 1

But one important piece is missing from the leadership ranks. The small stocks of the Russell 2000 RUT �are lagging the big stocks of the Standard & Poor�s 500SPX � in both daily and weekly time frames (see chart 1). I consider this as a problem for the market, especially as the seasonally strong winter half of the year winds down this month.

The chart shows a rather clear divergence between big and small stocks at the bottom of the last bear market. It meant that even before the market - including both big and small stocks - found its ultimate bottom in March 2009 the ratio of small stocks to big started to strengthen. Investors were not as interested in selling small stocks as they were in selling big stocks. It was a backhanded compliment but small stocks were back on investor minds with a positive spin.

Now, we see the S&P 500 make a higher high than it did in 2010 while the Russell is still far below its respective 2010 zenith. The ratio or relative performance of the Russell is once again diverging from the market only this time it has bearish implications.

Another ratio that seems to have run its course and is ready to turn is called the offense/defense ratio. Based on an idea from technical analyst Boris Simonder several years ago, my version is a ratio of so-called offensive sectors (technology and consumer discretionary) and defensive sectors (health care and consumer staples).

Using Select Sector SPDR exchange traded funds, the formula is Select Sector SPDR-Technology XLK �* Select Sector SPDR-Consumer Discretionary XLY � / Select Sector SPDR-Health Care XLV / Select Sector SPDR-Consumer Staples XLP . When the ratio is rising, as it has been since last December, we can say the offensive groups are in the lead and that is normally good for the market as a whole. And when the ratio is falling, investors are feeling more defensive and the market tends to struggle.

Chart 2

Right now, the ratio is still rising but it has run into the ceiling that stopped it at least six times since 2003 (see chart 2). The last time the ratio peaked in early 2010 was just a few weeks ahead of the S&P 500�s final high that year.

Again, the offense/defense ratio has not yet turned lower. But using standard technical analysis, such as momentum analysis, it is flashing warnings. As the ratio made a higher high, indicators such as the relative strength index made a lower high. Technical analysts call that a bearish divergence between the two.

With small caps already lagging, investors should pay attention to the performance of the sectors contained within the offense/defense ratio. If defense starts to outperform offense, it will probably be a good time to think about holding more cash.

Michael Kahn writes the Getting Technical column for Barron�s Online , which analyzes sectors and markets twice a week. Sign up for a free technical analysis chart of the day at QuickTakesPro.