The Divergence Between Large-Caps and Small-Caps
This is a topic that's been brought up plenty throughout the financial media and blogosphere recently. Money has been flowing into large-capitalization names, more specifically the Mega-caps, and out of the small and micro-cap stocks. We see this developing more and more every day. It's been one of the reasons that I've maintained a bearish/neutral stance for the US Stock Market Averages throughout this entire year.
But what do the statistics actually tell us about this money flowing up-cap? I sat through a great presentation on Thursday given by Piper Jaffray Managing Director and Technician Craig Johnson, CFA, CMT. This divergence is one of the reasons he mentioned why he's bearish over the 2nd and 3rd quarters of this year:
"The continued divergence between the Russell2000 index and the popular large-cap indices (DJIA and SPX) is a clear indication of weakening breadth and slowing momentum, and suggests investors are making an attempt to reduce portfolio risk by rotating assets toward the traditionally defensive area of the market.
To gauge the size of a possible decline we have identified years where the DJIA outperformed the RUT (a strong possibility for 2014), and measure the size of the market pullbacks that occurred in these years.....Thus, should the median pullback unfold this year, it would suggest a deeper correction in the broader market back towards 1,600-1,650 on the S&P500 Index."
Craig Johnson also noted that a lot of these years where we saw the mega-caps outperform small-caps were also mid-term election years. Historically, the stock market struggles during the 2nd and 3rd quarters in mid-term election years. So from a cyclical perspective, a continued market correction makes sense.
When we've seen these divergences, the S&P500 declines by 18% on average. The median decline under these circumstances is over 12% and they tend to occur over the course of several months. Right now the generals are the ones holding up the best. They're the last ones standing as money managers use them as a place to hide. I think this an unsustainable trend and we'll see them also correct soon enough.
As far as the small-cap underperformance that we're seeing, I would also expect that to continue. From a seasonal perspective, small-caps tend to underperform during the Summer and early Fall. My friend Jeff Hirsch, author of the Stock Traders Almanac, put together this seasonality chart of the Small-cap Russell2000 vs the Large-cap Russell 1000. Notice the upcoming seasonal weakness in this ratio:
"When the graph is descending, big blue chips are outperforming smaller companies; when the graph is rising, smaller companies are moving up faster than their larger brethren."
Stay tuned....
Sources:
Lagging Small-Cap Performance Likely to Last Until Q4 (AlmanacTrader)
The Informed Investors May 2014 (Piper Jaffray)
Tags: $IWM $RUT $IWB $SPY $SPX $ES_F $DJIA $INDU $DIA $YM_F