Small Caps Act Poorly On a Relative Basis

One of the more interesting developments since March began has been the severe underperformance out of the small-cap stocks. Coming into the week, the Russell2000 was actually in negative territory year-to-date. This compares to the large-cap S&P500 which is up 7% for 2014 and Dow Industrials up over 3%. This is a big difference. But the problem is what’s happening behind the scenes to this former leadership group.

Here is a chart of the Russell2000 relative to the Dow Jones Industrial Average. After really leading the way off the 2008/2009 bottom in US Equities, this ratio has potentially put in a deadly failed breakout:

7-21-14 rsk and djia

I recall earlier in the year, this “breakout” was getting a lot of attention, especially from the bulls. But in recent months, these guys have been crushed on a relative basis. Since the March 3rd closing highs, the Russell2000 is down 5% with the Dow Jones Industrial Average up over 5% during the same period.

Look at the 2006 and 2011 highs in the ratio serving as important resistance. It looks to me like the ratio is failing hard to stay above those highs. As we know, from false moves come fast ones in the opposite direction. So unless this ratio can get back above 69, the benefit of the doubt has to go to the bears on this one.

As far as market implications go, we want to see leadership out of the small-caps for evidence of risk appetite. We’re seeing some other divergences in the Bond market warning of the same thing. Seasonal studies suggest a week period for Stocks with higher volatility (see here). So this shouldn’t really come as much of a surprise.

I think a more neutral stance in stocks as an asset is likely to be the better position for the rest of the summer. We have some strategies in order to execute that (see here). So I’m going to continue to be cautious with small-caps, particularly on a relative basis. And this recent development to me is just another feather in the hat for the bears, at least for now.

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Tags: $IWM $RUT $DJIA $DJI $INDU $DIA $YM_F $SPY


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