The Small-cap Revolution

September 14, 2019

When was the last time Small-caps were not a mess? At least a year now right?

The bearish argument has been that small-caps (and others) are underperforming the large-cap stocks and therefore, the divergence is a warning signal that the market is about to fall apart. Along the way, I've asked the question,

What if we get rotation into small-caps rather than the rotation out of large-caps that you keep promising me?"

In other words, instead of the last ones finally falling, what if the stocks down in the dumps get their act together and start playing catch-up?

What does the market look like in that scenario?

Well, I'm still in the camp that we see the latter, rotation into small-caps, not the former where the S&P500 crashes and we go into recession. Here are small-caps relative to large-caps. If we are going to start to see outperformance from the little guys, this would certainly be a logical place for it to start:

Notice how when this ratio bottomed in early 2016, it was when stocks in general started to rally hard, following the correction (bear market?) of 2014-2015. Is this another risk-on signal from small caps?

I think so. But looking more broadly, it also looks like a bearish signal for Treasury Bonds. Look at US 10-year Yields overlaid with the Small-cap / Large-cap ratio:

I hate starting with the worst sectors, but this time we're going to do that to prove a point. They can't even keep the worst areas down, Energy. And what if we get back above the late 2018 lows? Here is the Small-cap Energy Index. If $PSCE is above 8, I think the squeeze higher is on:

On the complete opposite end of the spectrum is Technology, by far the strongest of all the Small-cap sector indexes. It looks to me like a breakout in Small-cap Tech is coming soon. If we're above 90 in $PSCT what is there to be bearish about?