Small-Cap Selloff a Bad Omen for Stocks

by Dan Burrows | April 17, 2013 1:55 pm

Small-Cap Selloff a Bad Omen for Stocks

The crisis in Cyprus couldn’t do it. The shocking slowdown in China’s economy couldn’t do it. Not even the tragedy of the Boston Marathon bombing could get stocks to definitively roll over.

They sure have gotten a lot more wobbly, though. The Dow Jones Industrial Average suffered a triple-digit plunge after Wednesday’s opening bell, extending a wild ride. The blue-chip index gained and lost more than 550 points before the week was even half over.

But anyone watching small-cap stocks — often the canary in the equity market coal mine — couldn’t be too surprised.

As we’ve noted before, stumbling small-caps often suggest market weakness[1] ahead. So it’s more worrisome than ever that the small-cap benchmark Russell 2000 index has gone from relative-but-still-positive underperformance to an outright breakdown.

Yes, the broader market is still churning higher. The S&P 500 remains up a solid 9% for the year-to-date. But equities aren’t advancing in quite the way that they should. More defensive blue-chip stocks have taken leadership away from the smaller, riskier stocks, and that’s often a sign of trouble ahead.

One healthy characteristic you want to see as the market moves higher is relative outperformance on the part of small-cap stocks. Smaller companies tend to be higher-risk, higher-reward plays. They have much greater growth prospects, for one thing — it’s easier to double sales from, say, $1 billion to $2 billion than from $10 billion to $20 billion.

Additionally, because they get less media and analyst attention, small caps are more likely to be mispriced.

But they’re also riskier. They’re less liquid, which can make them more volatile, and volatility increases the chance that you’ll buy high and sell low. Small caps companies also are more dependent on credit, since they plow so much cash back into building their businesses. They tend to have less diversified revenue streams, too.

When small caps are leading the market higher, it usually means investors are embracing riskier, more speculative bets, which in turn helps make the case for stocks in general.

So when small caps are no longer outperforming their bigger-cap cousins or are even suffering declines, you have to be at least a little bit concerned that the broader market might soon stumble.

Have a look at the chart below, courtesy of S&P Capital IQ, and you’ll see why some traders and investors are starting to worry that risk appetite in the equity markets is starting to wane:

smcapsCHART Small Cap Selloff a Bad Omen for Stocks[2]

Since peaking on March 14, the small-cap benchmark Russell 2000 is off 3.1%. The broad-market benchmark S&P 500 is almost flat on a price basis, gaining 0.7% over the same period. Meanwhile, the Dow — that more defensive bastion of 30 large- and mega-cap stocks — gained 1.5% since mid-March.

The market always trades on some combination of fundamentals and technicals, and while the fundamentals in the form of first-quarter earnings and outlooks have mostly been supportive of equities, the technicals — in small caps, at least — are more worrisome.

The Russell 2000 would have to close above its 50-day moving average of 929 to negate Monday’s breakdown, the Wall Street Journal’s MoneyBeat[3] blog reported Wednesday. Until then, the short-term downside target remains around 880, according to Jay Lefkowicz, technical strategist at Concept Capital Markets.

With the Russell 2000 currently at 909, the index needs to gain 2.2% to break its 50-day moving average. The downside target represents a decline of another 3.3%.

Whichever way it breaks, traders and investors would do well to pay notice to the often prophetic small-cap stock index. The direction of the broader market could very well be at stake.

Endnotes:
  1. stumbling small-caps often suggest market weakness: http://investorplace.com/2013/04/stumbling-small-caps-suggest-market-weakness-ahead/
  2. [Image]: http://investorplace.com/wp-content/uploads/2013/04/smcapsCHART.jpg
  3. MoneyBeat: http://blogs.wsj.com/moneybeat/2013/04/17/morning-moneybeat-no-all-clear-signal-yet/

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