Big Weakness in Small Companies

by Tyler Craig | August 2, 2012 8:47 am

A brief survey of the market landscape reveals an increasingly disparate environment of haves and have-nots. While big-cap stocks continue to welcome newcomers into their ranks, their smaller brethren are increasingly becoming the victims of risk aversion.

Consider the stark difference in performance between the S&P 500 Index with its large-company constituents and the Russell 2000 Index, which many consider the benchmark for small-cap stocks. As the chart below shows, the exchange-traded fund for the S&P 500, the SPDR S&P 500 (NYSE:SPY[1]), has climbed approximately 1.7% since July 9, while its Russell 2000 counterpart, the iShares Russell 2000 Index (NYSE:IWM[2]), has fallen 4%.

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The contrast between these two segments of the stock population reached new heights in Wednesday’s trading session with the SPY closing the day virtually unchanged — while the IWM fell 1.65%.

The trouble with the continued underperformance in small caps is that it reveals investors’ lack of appetite for risk, which points to a stock market built on a shaky foundation. Without the participation of this broad swath of higher-beta stocks, the continued rise in equities appears in jeopardy.

Of course, the divergence can resolve itself in one of two ways. Either large-cap stocks succumb to the growing theme of risk aversion and fall from their current heights, or small-cap stocks shake off their weakness and begin to play ball with the big boys.

Perhaps the continued underperformance in the Russell 2000 is due in part to widespread concern over the tepid recovery playing out in the good ol’ U.S. of A. With smaller companies unable to establish as much of a footprint abroad, their profits rely heavily on the strength of the domestic economy.

Such a fear also seems to be affecting the performance of the economically sensitive transportation sector. The ETF for the Dow Jones Transportation Index, the iShares Dow Jones Transport. Avg. (NYSE:IYT[3]), has matched the relative weakness of small caps in recent weeks, as well as in Wednesday’s trading session when it fell over 2%.

So, how might this affect your trading?

If you’re inclined to buy the current market pullback once it terminates, consider focusing on big-cap-related ETFs like the SPY or DIA while avoiding the IWM and IYT. It might also not be a bad idea to maintain a healthy degree of skepticism of the current market uptrend until the small caps jump aboard the bull train.

At the time of this writing Tyler Craig held neutral positions in RUT.

  1. SPY:
  2. IWM:
  3. IYT:

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