Stumbling Small Caps Suggest Market Weakness Ahead

by Dan Burrows | April 3, 2013 1:45 pm

It’s always something.

Sure, stocks just set a new all-time closing high, but in the days leading up to the S&P 500‘s record close, cracks started showing up elsewhere in the equity market.

Don’t look now, but small-cap stocks — which tend to lead markets both higher and lower — are starting to stumble.

As we’ve written previously, one key thing you want to see when the market is chugging along is relative outperformance on the part of small caps[1]. Smaller companies naturally have exponentially greater growth prospects, if only because it’s easier to double sales from, say, $1 billion to $2 billion than from $10 billion to $20 billion.

But they’re also riskier. Small caps are more dependent on credit, for one thing, since they plow so much cash back into growing the business. They usually have less diversified revenue streams, too.

When small caps are leading the market higher, it means investors are embracing riskier, more speculative bets, which in turn helps affirm the case for equities in general, and suggests the broader market will follow. But when small caps are no longer outperforming — or even falling? That might mean the market’s appetite for risk is beginning to wane.

So it’s a least a little bit worrisome that the small-cap benchmark Russell 2000┬áindex might be running out of gas. And, in another trend suggesting investors might be getting more defensive, large- and mega-cap stocks are pulling ahead.

Here’s a one-month chart, courtesy of S&P Capital IQ, showing the relative performance of small-caps vs. large caps, using the Russell 2000 and Dow Jones Industrial Average as proxies:

SmCap CHART Stumbling Small Caps Suggest Market Weakness Ahead[2]

Not only are small caps not leading the way higher, they’ve actually taken a turn for the worse in the past week. During the four trading sessions ended April 2, the Russell 2000 slipped 1.8%. The Dow, meanwhile, added 0.6% over the same span.

That could mean the market’s starting to get more cautious and protective of recent gains. As Jonathan Krinsky, Miller Tabak’s chief technical analyst, said in a recent note to clients (hat tip to Business Insider[3]):

“Generally, when the small-caps show relative weakness vs. the large caps, it is a sign that investors are moving out of the riskier/high-beta names and into the ‘relative safety’ of the large/mega-caps.”

Small caps rolling over is by no means indicative of the broader market topping out, Krinsky notes. It’s happened before, after all, as recently as last summer, and the S&P 500 still managed to grind higher back then.

But it should give investors pause.

After gaining 10% in the first quarter alone, the S&P 500 has already surpassed plenty of Wall Street strategists’ price targets for the full year. Technicals, experience and just plain common sense say we’re due for a pullback — which is big factor contributing to the relative attractiveness of large caps right now.

Hey, if you’re worried about a market retreat, you’re going to take profits on your hot-growth small caps and rotate into bigger, more defensive names.

If the broader market does stall out, small caps will be in front of the selloff too. And it might take a 5% to 10% downside move — or more — before they reclaim the pole position on the way back up.

Endnotes:
  1. relative outperformance on the part of small caps: http://investorplace.com/2013/02/a-comforting-norm-small-mid-cap-stocks-leading-the-way/
  2. [Image]: http://investorplace.com/wp-content/uploads/2013/04/SmCap-CHART.jpg
  3. hat tip to Business Insider: http://www.businessinsider.com/djia-russell-2000-ratio-versus-sp-500-2013-4

Source URL: http://investorplace.com/2013/04/stumbling-small-caps-suggest-market-weakness-ahead/
Short URL: http://invstplc.com/1fqMUTO