Yes, Small Caps Really Are That Much Healthier Than Large Caps Are Right Now

Posted by jbrumley on June 18, 2018 10:44 PM

The reason is up for debate; there may be more than one explanation. Then again, the reason or reasons don't really matter. What matters is that small cap stocks are forging ahead, and it ain't an accident or a fluke. This sliver of the market is the real deal - for the right reason - and should remain in charge for the foreseeable future.

Putting some numbers to the premise, the S&P 600 Small Cap Index is up 22% for the past twelve months, versus the S&P 500 Large Cap Index's 13.1% gain for the same timeframe. Year-to-date, the S&P 500 is only up 3%, and the average small cap is up 11%.

The likely/looming trade war is getting most of the credit for the disparity. Smaller U.S. companies rely less on overseas companies and overseas suppliers, so they're not at risk like major, international outfits.

If we're being intellectually honest though, small cap stocks have more than 'earned their stripes.' Rather than a mere philosophy about winners and losers of a tariff war, the S&P 600's constituents are putting up some serious growth numbers. Last quarter's year-over-year earnings growth was 29%, following Q4's 30% improvement in bottom lines. For the quarter underway, profits are expected to be up 59%.

It's not stroke of mathematical luck that's setting up that kind of growth either. The S&P 600 started to grow the bottom line again in early 2016, and has every quarter since then. Granted, some of the comps were rather easy bars to clear. We're now into two straight years of growth though, the S&P 600's trailing P/E of 27.5 is almost back to normal, and still falling.

In other words, the fundamentals are attractive, for all the right reasons. [The white arrow is the first quarter's result; everything to the right is an outlook.]

That's not the really interesting - and bullish - part of the small cap story right now though.

We've talked from time to time about the importance of using breadth (advancer/decliner) data and depth (up volume and down volume) data as a means of measuring the strength and belief in a trend's undertow. Though we usually consider the NYSE's breadth and depth information and apply it to the S&P 500, we have the same data and can make the same analysis for the Russell 2000 Small Cap Index. So, we did, and not surprisingly, it's bullish... far more bullish than the comparable data for large caps.

The graphic below plots the Russell 2000, and compares it to the Russell 2000's "up" volume trend (green) and its "down" volume trend (red). Unlike its large cap counterparts, the Russell 2000 started to grow its bullish volume again early this month, while its bearish volume hasn't started to trend higher. [The faint, thin lines are the raw daily data, and the thicker, brighter lines are a moving average of the daily data, indicating the underlying trend.]

That's in contrast to the NYSE's bullish and bearish depth, as the image below illustrates. These names collectively rolled over just a few days ago, in terms of volume.

The same basic idea applies to the Russell 2000's breadth, That is to say, we've seen more winning stocks than losing stocks within the Russell 2000. Both trends flattened as of late May, but as a closer look at the chart below shows, there's a bullish divergence re-forming here.

That's in contrast with the large cap market, which is increasingly leaning in a bullish direction again. That's what the graphic below shows.

There's more.

Along the same lines, the sheer number of Russell 2000 stocks above their 50-day moving average lines and above their 200-day moving average lines is a far stronger than the number of S&P 500 stocks above their 50-day and 200-day moving average lines.

The image below tells the tale, plotting the percentage of Russell 2000 names above the 200-day moving average line (green), above the 50-day line (orange) and the Russell 2000 at the bottom (blue). A little more than 64% of small cap names are above their 200-day line, and more than 75% of them are above their 50-day moving average lines.

That's much better than the S&P 500. Of its constituents, only 59% are above the 200-day moving average line. Only 66% are above their 50-day moving average lines.

As for what it all means, take it at face value. Small caps are well supported, and well loved, for fundamental and strategic reasons.

That's not to say the Russell 2000 or the S&P 600 is bulletproof, or impervious to a pullback. It is to say, however, that these names aren't just randomly drifting higher and subject to a random rollover. This is deliberate, well-thought-out bullishness that investors would be wise to take seriously. That's the case whether or not the trade war that works against large caps escalates.