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What Small-Cap Leadership Really Means for Stocks

When the RUT outpaces the SPX, short-term gains are just the tip of the iceberg

Senior Quantitative Analyst
Jun 13, 2018 at 6:00 AM
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The Russell 2000 Index (RUT) has been making new highs for a few weeks now, but the S&P 500 Index (SPX) is still more than 3% off its previous peak. In fact, by one measurement that we’ll look at later, we recently saw the biggest small-cap outperformance since 2010. It's been said that it’s a bullish sign when small-caps outperform because investors are gaining confidence to take on more risk, so with the analysis below, we'll look to see if the numbers confirm that.

Iotw Chart 1 Small Caps

Short-Term Gains After RUT Outperforms, And Then...

On May 30, the three-month relative strength of the RUT reached its highest level since March 2010. That previous instance coincided with a tough time for stocks: the SPX fell 6% over the following six months, while the RUT fell 7%. Hopefully, this time doesn’t play out the same way.

Going back to 1979 (as far back as we have RUT data), I looked at each time the three-month relative strength of the small-cap index reached 1.08. It has occurred 33 other times, and the table below shows how the SPX performed after these occurrences. Then, the second table shows "anytime" returns for comparison.

In the short term, this has been a bullish sign for the market. The SPX's average one-month return of 1.52% after a signal easily beats the anytime return of 0.80%.

Things change, though, after that first month. When you get to three months after a signal, the average SPX return drops from 1.52% to 0.82%. That three-month return is significantly worse than the typical 2.41% return. At six months, the data still shows underperformance, with the average SPX return of 1.97% less than half the anytime six-month return of 4.93%.

Iotw Chart 2 Small Caps

These next tables show the RUT returns. As you might expect, just like the SPX, the index outperforms in the first month after a signal -- but then underperforms over longer time frames. These signals have tended to lead to strong returns over the next month, but over the longer term, stocks have struggled in such instances.

Iotw Chart 3 Small Caps

SPX Returns Look Worse as the Focus Narrows

Out of those 33 returns above, many of them occurred in especially strong market rallies or downturns. In the most recent signal, the SPX was about flat over the past three months, while the RUT was up between 8% and 9%. To narrow the results to signals that occurred during similar market environments, below are the returns when the RUT outperformance coincided with a preceding three-month SPX return of less than 5%. This leaves us with 10 prior signals.

Again, we see outperformance in the first month of returns, but this time the longer-term returns are even worse. The average SPX returns three months and six months later are now negative.

IotW Chart 4 Small Caps

For the RUT, the index averages a 3.83% loss three months after a signal, and a 4.53% loss six months after a signal. On balance, the data in this study seems to weaken the theory that small-cap leadership is bullish.

Iotw Chart 5 Small Caps

 
 

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