What a ride! Back in September, if you had asked most traders on Wall Street where they thought the S&P 500 would currently be trading, most of them would have told you they expected it to be below 2,000. But then October happened.
In early October, sentiment on Wall Street made a dramatic about-face, and we watched the S&P 500 easily break through resistance at 2,000 and move back up into the consolidation range where it had been from early February through mid-August.
This means everything is back to normal, right? Well…not so much.
While the S&P 500 has certainly made a dramatic rally, small-cap stocks have been noticeably lagging. This is primarily due to the fact that traders’ risk tolerance has shifted this year. Where traders were once willing to take on more risk in the pursuit of strong growth and high returns, they are now looking for more security.
Large-Cap versus Small-Cap
When optimism levels change on Wall Street, you can see it play out in the relationship between large-cap and small-cap stocks.
Large-cap stocks are typically mature, dividend-paying stocks with healthy balance sheets, stable businesses and plenty of liquidity. Conversely, small-cap stocks are typically non-dividend-paying growth stocks with less stable balance sheets, volatile businesses and less liquidity.
During periods of confidence and exuberance on Wall Street, traders are more willing to forgo dividends, overlook balance-sheet weaknesses, endure increased volatility and accept less liquidity in pursuit of higher returns. However, during periods of concern and uncertainty on Wall Street, traders are more focused on receiving predictable dividend payments, ensuring balance sheets are strong, reducing volatility and keeping their options open with plenty of liquidity as they seek to protect their portfolios.
That means traders typically skew more toward small-cap stocks when they are confident and more toward large-cap stocks when they are less confident.
You can see this play out in a comparison between the charts of the SPDR S&P 500 Trust (SPY) — an exchange-traded fund (ETF) that tracks the large-cap stocks that make up the S&P 500 index — and the iShares Russell 2000 ETF (IWM) — an ETF that tracks the small-cap stocks that make up the Russell 2000 index.
SPDR S&P 500 Trust versus iShares Russell 2000 ETF
After the dramatic pullback in the stock market during October 2014, SPY and IWM both rebounded. However, the magnitude of the rebound was different for each.
Looking at the chart for SPY in Fig. 1, you can see it rebounded by 17.49% before hitting its last 52-week high.
Fig. 1 — Post-October 2014 Rebound on SPY
As you can see in Fig. 2, IWM enjoyed a much larger rebound — climbing 24.66% before establishing its last 52-week high — as traders gained confidence and shifted more money into small-cap stocks.
Fig. 2 — Post-October 2014 Rebound on IWM
Unfortunately, the uncertainty that crept into the market during the summer of 2015 took a heavier toll on small-cap stocks than it did on large-cap stocks as traders became increasingly nervous about the future.
Looking at Fig. 3, you can see that IWM dropped by 17.12% to its recent lows, while SPY only dropped 14.67% (see Fig. 4).
Fig. 3 — Summer 2015 Decline on IWM
Fig. 4 — Summer 2015 Decline on SPY
Wall Street’s subsequent rally during the past two months has been encouraging, but it has also been telling. It shows that traders are much less optimistic and enthusiastic than they were a year ago. If they were just as optimistic, we would expect to see small-cap stocks leading the charge higher, but that is not the case.
As you can see in Fig. 5, SPY has rebounded by an impressive 16.05% off its recent lows, but IWM has only rebounded 11.56% off its lows (see Fig. 6).
Fig. 5 — October 2015 Rebound on SPY
Fig. 6 — October 2015 Rebound on IWM
This rebound put SPY within 0.98% of its 52-week high (see Fig. 7), while leaving IWM a distant 7.54% away from its 52-week high (see Fig. 8).
Fig. 7 — Distance from SPY’s 52-week high
Fig. 8 — Distance from IWM’s 52-week high
Obviously, small-cap stocks have not enjoyed the same exuberant rally as large-cap stocks.
This shift in optimism on Wall Street is important. There will be plenty of bullish opportunities if stocks continue to climb, but our approach must be measured. We can’t assume that stocks will run higher unchecked like they do in some market environments. We also have to be prepared for turnarounds, as investors are skittish and uncertain. This should give us a good balance of bearish trading opportunities as well.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.
