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Small Cap Weakness Points to Market Correction

At key times, small-caps and large-caps diverge


Stock have been moving lower this week. But the severity of the decline depends on which market index you like to watch. If you’re like most retail investors, the Dow Jones Industrial Average is your preferred benchmark. And it’s been pretty much flat over the last few days, trading near its recent closing high of 11,834.

But it’s a much different story for the small cap issues in the Russell 2000, which is down about -3.5% from its close last Friday. Frequently, you’ll see big disparities in the performance of small cap stocks vs. the mega cap stocks at turning points — almost as if the Wall Street heavy hitters want to throw the investing public, who closely track the Dow, off the scent.

stock market chart

One way to look at the performance gap between the Dow and the small caps in the Russell 2000 is to take a ratio of their prices. Wednesday’s 2.5% jump in the Dow relative to the Russell 2000 is the largest since May 2009 — a move that marked the initiation of the first correction after a rally from the bear market lows in March 2009. Other examples of large relative moves by the Dow include the initiation of the October 2009 pullback and the decline out of the April 2009 high.

Clearly, the performance gap suggests lower prices lie ahead. Remember that periods of large cap outperformance relative to small caps are associated with periods of weakness for the overall market. Think of small stocks are the infantry of an army. If they leave the battlefield, like they are now, the generals still on the field get slaughtered.

A healthy market is led by small stocks — since they are the most sensitive to the economic and liquidity catalysts that push and pull the equity trade. The opposite is happening now.

It’s another sign that all’s not well, and that it’s time to prepare for a market correction.

Right now, weakness seems to be concentrated in dollar-sensitive issues like precious metals, crude oil, emerging market equities, and basic materials stocks. I’ve recommended the ProShares UltraShort Silver (NYSE: ZSL) to my newsletter subscribers — and the position is now carrying a 14% gain since we added it earlier this month. We’re also holding the ProFunds UltraShort Russell 2000 (NYSE: TWM), which is up nearly 7% over the last two days. Both are still attractive buys at current levels.

Disclosure: Anthony does not own or control a position in any of the companies or funds mentioned, but has recommended ZSL and TWM to his newsletter subscribers.

Be sure to check out Anthony’s new investment advisory service, The Edge. A two-week free trial has been extended to Investorplace readers. The author can be contacted at Feel free to comment below.

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