Small Caps Facing an Uphill Battle

Posted by jbrumley on September 19, 2018 11:05 PM

The last few days have been ok for the market. Not great, but ok. Since the end of August, the S&P 500 has edged a bit higher, shrugging off some renewed worries about the tariff war. Even better is the fact that the market is holding up in a month that's generally rough for stocks.

One group of stocks has been conspicuously missing from the bullish picture though. That's small caps. The S&P 600 is down 2.5% since the end of last month, unwinding a decent-sized chunk of the leadership it had enjoyed since April.

Yet, there's much more ground to give up, and plenty of reason to worry the S&P 600 may well give up that ground before all is said and done.

The graphic below tells the tale. Up more than 27% for the past twelve months at one point not that long ago, the S&P 600 has since suffered even though large caps and mid caps held their ground.

The reason? It's not perfectly clear, and there may be more than one factor in play. Chief among those factors is a reversal of the assumption that the tariff war would be prolonged. More than a few investors steered clear of vulnerable large caps and sought out small caps over the course of the past several months largely because small caps aren't as exposed to tariffs as their large cap brothers are. [That's not an accurate assumption, but an assumption nonetheless.] With a seeming end to the tariff war on the horizon, investors are replacing small caps with large caps.

Also contributing to the oversized leadership from the S&P 600 was the raw strength of the economy.

Small cap stocks generally outperform other sized stocks, though they're erratic. It's easy to doubt their capacity to hold their ground. When the economy is raging though, small cap stocks tend to perform very well, profit-wise and stock-performance-wise. In the shadow of two 4%+ quarters of GDP growth, assumptions of economic strength are easy to make. Sustainability of such strong growth, however, is now coming into questions. Nervous investors are turning that worry into the selling of the most vulnerable (and most overbought) names.

And just for the record, almost all small cap sector indices are losing ground. It's not as if one unlucky group is unfairly dragging the whole sector lower. The one exception? Materials. The S&P 600 Materials Index is up for the month so far... the only small cap sector to boast a gain.

The market's small cap breadth and depth have also turned net-bearish... again.

The images below will look a bit familiar to regular BigTrends readers, though there's a twist with these particular looks. Rather than comparing the S&P 500 to the overall market's advancers, decliners, up volume and down volume, we're comparing the Russell 2000 - another small cap stock index - to its up and down volume, and its advancer and decliner data. As we usually do though, we're more interested in comparing moving averages of this data, as the raw daily data is too erratic to use and analyze.

First is the Russell 2000 and the up volume and down volume trend at the bottom of the chart. The recent cross of the red line above the green line at the bottom of the chart says there's been more bearish volume among small caps of late than bullish volume.

It's not like we've not seen such bearish crossovers before, to no avail. Maybe this one will be undone like all the rest. Or, maybe not. It's at least a red flag.

The Russell 2000's advancer/decliner trend data is also a red flag.

Again, this signal may be undone in a matter of days. It's far from a sign that all is well though. Small caps are at least on the defensive.

And for what it's worth, from mid-September to mid-October is usually a rough time for small caps anyway. The S&P 600, on average, loses 2.4% of its value for this stretch (though in its defense it soars from mid-October on).  The index is starting out this phase of 2018 well overextended, above even its average performance-to-date for a bullish year.

The Russell 2000 has made lows of right around 1700 for the past three days, but remains in a downtrend. One move below that recently-developed floor could push the index past the tipping point, letting the recent weight of small caps' gains take a bigger toll than it already has.

A guarantee? No, those don't exist... particularly in the world of trading. It's more than enough to think about, however, if you have more than a little bit of exposure to small cap stocks.