What's Up With the Small-Cap Underperformance?

Throughout the month of February, small-caps got crushed relative to large-caps. But the ratio has somewhat stabilized in March. Can we expect the small-cap Russell 2000 to get back on track vs the larger-cap S&P500? I mean we did see 4 months of absolute dominance in smaller-capitalization stocks off the October lows.

Think about it, from the October lows up to February 3rd, the Russell2000 was up a monster 38% compared to a 25% return in the S&P500 and just 23% for the Dow Jones Industrial Average. Since then the Russell 2000 is actually down (as of Friday's close) while the large-caps have continued on to higher highs.

So here's how I see it: The Russell2000 started to roll over relative to the S&P500 last July, breaking down well before the major large-cap averages (in other words - leading us lower). After finding some temporary support throughout August, the ratio rolled over again in September making lower lows down to early October. That last rollover was devastating as the former range of support turned into 2 months worth of resistance for the rest of the year.

And that's when the fun started again. The stock market exploded to begin 2012 and the small-caps were the leaders in January. It had taken 2 months (Nov & Dec) to break through resistance, but the little guys got it done.

But then February came, where large-caps once again took over. The small-caps got crushed compared to larger-cap stocks and brought the ratio back to that former range of resistance. Will that resistance (that was support back in August) turn into support again?

Well it certainly looks that way. The Russell2000 has been outperforming throughout March and the Relative Strength Index (RSI) has remained in Bull Mode even during the recent correction. This is a positive, not just for the Small-caps, but for the US Stock Market overall.

If money is trying to be aggressive and has to be put to work, you are likely to see smaller-cap (theoretically riskier) names outperform larger (theoretically less risky) names. As we saw in July, this ratio tends to lead the broad markets. If small-caps can keep going here, both on an absolute basis and relative to large-caps, then I think the bias in trading individual names needs to stay on the long side.

If small-caps start to roll over and this potential support (that was formerly 2 months of resistance in November and December) cannot hold, then I would be much more gun-shy about initiating new long positions. A more defensive stance would be more appropriate in that case.

But here we are on a Monday morning with the Russell2000 up twice as much as the S&P500. Here we go again? Let's keep this ratio handy.

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