The past week was a disappointment for buyers of large company stocks, as the Dow fell 0.5% despite the massive interest rate cut by the Federal Reserve on Tuesday. But small cap stocks were actually on the move all week, as the Russell 2000 rose all but one of the days while posting a gain of 3.5%.

The fact that small caps are beginning to outperform large caps is a sign of a bigger set of events afoot in the global economy. Large companies are obviously multinationals, while smaller companies tend to focus on domestic U.S. sales. So whenever we see a big disparity in the performance between the two, it’s a heads-up that investors believe there is an imbalance in the world.

The proxy for small cap stocks, the Russell 2000, has risen 26% since the lows of last month, while the S&P 500 large caps have advanced 18%.

These kinds of numbers are always a bit bogus when it comes to performance, since they assume that someone magically would have bought the exact bottom and held until today, but the idea is simply that there is finally a big disparity in two key asset groupings, and that is hugely useful for our effort to understand what is going on as well as our ability to do something about it.

Why Small Caps?

The advance of the small caps is a signal that investors have come to believe that the U.S. economy has a chance to grow faster in the coming months than the rest of the global economy. This differential persisted through most of the 2000-2003 bear market, and provided a way for nimble investors to hide out from the pain suffered in the broad market.

It’s still too early to tell whether the differential will persist again over the coming year, but…

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…this is a very important development to watch. One of the most egregious problems investors have faced over the past six months is that all asset groups, classes, sectors, regions and commodities have traded down in synch. The financial statisticians’ way of saying this is that all correlations have gone to 1.0.

Now that we can see the Russell 2000 has surpassed its Dec. 8 and high and its 50-day average, it provides us with some hope that the new differentiation that I have spoken of in recent weeks is finally playing out. The S&P 500, Dow and Nasdaq have all failed to spend more than one day over their 50-day average, and none is above its Dec. 8 highs.

Sectors Fairing Better Than Others

Some sector groups have also eclipsed their Dec. 8 highs and 50-day averages. They include three to which I have recommended exposure: Global Telecom (IXP), Metals and Mining (XME) and AgriBusiness (MOO).

Groups that are have not, and to which I have recommended no exposure, include energy (XLE), finance (XLF), technology (XLK) and industrials (XLI).

The only way to beat the market is to avoid what’s not working and own what is working. In short, always fight with the winning side. Now that includes small caps, telecom and agriculture.

What’s wrong with large caps? One of the main issues is that credit remains tight despite the Fed’s incredible efforts to loosen them up. Junk bond spreads narrowed by 38 basis points on Tuesday of last week, for instance, which sounds good until you realize that they had widened by 52 points the prior day.

Independent debt analyst Brian Reynolds also reports that the prices of bank loans — those credits at the top of the capital structure, meaning they get repaid first in the event of bankruptcy — did not improve last week at all. His reading of the action leads him to think that the bear community, which is extremely well-funded after having eaten sumptuously all year — is just laying low right now as it waits for stocks to move higher.

He believes that the 1,050 area of the S&P 500 would be the likely planned kill zone, and that if stocks somehow get through that the bears would regroup at around 1,075 and retreat back to the 1,210 to 1,275 area before launching a renewed attack with all they’ve got. I believe that battle plan is right on target.

I’ll keep monitoring this for my Trader’s Advantage subscribers, but keep a battle map of your own as well.

This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com.