What Small-Cap Underperformance Could Mean for Stocks

Small-cap stocks have been underperforming substantially compared to big-caps over the past few months. The large-cap S&P 500 Index (SPX) has been around breakeven since the end of January, while the small-cap Russell 2000 Index (RUT) is down just over 10%. The last time the RUT was down double-digits over a three-year period while the SPX was positive was May of 2000, was just before the tech bubble burst leading to a two-year bear market. This week, I’m looking at how stocks have performed going forward depending on the performance of the RUT compared to the SPX.

Small Cap Relative Strength

The chart below shows the SPX along with the three-month relative of the RUT. The relative strength has collapsed to below 0.9. This suggests investors are becoming more risk-averse, selling off riskier stocks in favor of steadier big-cap names.

Going back to 1990, I found how the S&P 500 performed going forward based on the three-month relative strength of RUT to the SPX. The table below shows the returns over various time frames. The first row corresponds to the current situation, when small caps underperform big caps by a lot. Specifically, it’s when the relative strength reading is been between 0.79 and 0.96. The middle row is when the indexes perform similarly. Then the bottom two rows are when small caps outperform vs. big caps.

If the small cap underperformance indicates investors are becoming risk-averse, then this has been a good contrarian indicator. The S&P 500 had the highest average return going forward when big caps were outperforming over the prior three months. The index has averaged double-digit returns over the next year when small caps underperformed the big caps. When small caps have outperformed the most, the S&P 500 has averaged 5.5% over the next year. This tendency also exists at shorter time frames.

Here’s a similar table showing the returns of the Russell 2000 going forward. The conclusion is the same for the small cap index. When small caps underperform over a three-month period, stocks tend to do well going forward.

I did the same analysis as above except I limited it to times when the S&P 500 was up or down no more than 2.5% over the previous three months. This prevents the groups from being skewed by results that occurred in an extreme market environment. The tables below reach the same conclusion as the ones above. When small cap stocks underperformed big caps over a three-month period, stocks in general tended to do well going forward.

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