What This Rare Small-Cap Signal Might Mean for Stocks

Data doesn't back up claims that small-caps are the canary in the coal mine

by Rocky White

Published on Jul 31, 2019 at 6:50 AM
Updated on Jul 31, 2019 at 6:50 AM

Over the past year, the Russell 2000 Index (RUT) -- a barometer of small-cap stocks -- is down over 7%, while the large-cap S&P 500 Index (SPX) is up over 6%. A popular notion is that when there is a divergence between small-cap and large-cap stocks, the direction of the small-caps predicts the future direction of the market in general. This would be bad news, based on that popular notion. I have found, however, that many of these often-repeated axioms don’t hold up to scrutiny when you try to confirm them with actual numbers. In the analysis below, I look at this claim a couple of different ways to see if I can find actual data to support it.

7.30 iotw chart 1

Year-Over-Year Relative Strength at an Extreme Low 

The year-over-year relative strength of the Russell 2000 versus the S&P 500 fell below 0.85 last month. Relative strength measures the change in the Russell 2000 as a proportion of the S&P 500. A reading of 1.0 means they returned the same exact percentage, while a reading below 1.0 means the Russell 2000 Index underperformed.

The 0.85 level had only been reached five other times since 1980 (only one reading over a year period). Those prior instances are listed in the table below. Note that the last time this occurred was way back in 1998. Looking at the subsequent S&P 500 returns, the results seem bullish, with the 12-month returns all in the double-digits.

IOTW 2 - SPX on RUT RSI

The table below summarizes the returns in the table above. The second table shows typical SPX returns since 1980. In these instances of small-caps underperforming, it was not at all bearish for the market. Those are very bullish returns.

IOTW 3 - SPX RUT RSI

Here's similar return data after these dates for the Russell 2000. The short-term returns (one- and three-month returns) are bearish or neutral. The six-month and one-year returns, just like above, outperformed substantially.

7.30 iotw chart 4

100 Days Below 1.0

Last week, we saw the 100th straight trading day in which the RUT's year-over-year relative strength was below 1.0. There were 15 other times since 1980 when the relative strength was below 1.0 for this length of time. The implications are similar, even with more data points.

The tables below show how the S&P 500 and Russell 2000 performed after these signals (recall that above there are tables with typical returns for each index that you can use to compare). At every timeframe below, from one-month to a year, the S&P 500 had a higher-than-usual average return and a higher-than-usual percentage of returns that were positive.

The same is almost true for the Russell 2000, but the percent positive for one-month returns was 60% after a signal, compared to 61% anytime. Still, again, the claim that small-cap stocks are the canary in the coal mine for the market going forward isn’t supported by the data.

IOTW 6

IOTW 7

This last table shows S&P 500 returns following the last 10 occurrences of the Russell 2000 relative strength being below 1.0 for 100 straight days. It signaled in January 2008, during the financial crisis. There have been three occurrences during the subsequent long-term rally. Twice the large-cap index gained double-digits over the next year, and the other time it was barely above breakeven. Overall, the numbers are supporting the narrative that small-cap underperformance is not something to be worried about.

IOTW 4 - SPX sub 1 RUT RSI


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