Small Cap Performance is Worrisome.

What’s going on in the small cap space?

Over the past several days we have seen a huge divergence between large cap and small cap stocks. Looking at the figure below, the SPY (S&P 500) ETF is up 0.6% over the past twelve days. Over the same time frame both the DIA (Dow Jones Industrial Average) ETF and the QQQ (Nasdaq 100) ETF are up 1.0% and 0.8%, respectively. The IWM (Russell 2000) ETF is DOWN 2.0%!

According to research provided by North American Journal of Economics and Finance, Empirical studies show that “small-cap firms outperform large caps over the year subsequent to an economic trough. In the year prior to the business cycle peak, however, small caps tend to lag.”*

If there are concerns about the true growth in the economic cycle, one would expect to see a sector rotation out of small cap stocks into large caps, as we are seeing today. What is also interesting is the relative weakness in the metals market (take a look at copper).

Small Cap Weakness

Our behavioral model as it relates to the small cap sector is indicating the need to take some profits off the table. Looking at the chart below, one can see that the trigger line (gray) has aggressively fallen below the trend line (orange) and has broken the upper euphoria line to the downside.

Obviously it is impossible to call the market top based on just one sector meltdown, but taking into account the movement out of the economically sensitive small-caps and a rotation into large caps it warrants further attention. This also coincides with our last note indicating a rotation into economically defensive sectors such as health care, consumer staples and utilities.

Bottom Line: It is prudent at this time to lighten up on our small exposure.

- Joseph S. Kalinowski, CFA

*The Behaviour of Small Cap vs. Large Cap Stocks in Recessions and Recoveries: Empirical Evidence for the United States and Canada. By Lorne N. Switzer, Concordia University, Quebec - Department of Finance. December 2010. North American Journal of Economics and Finance, Vol. 21, pp. 332-346, 2010