Small-cap stocks have significantly underperformed larger-cap names this year
Stocks have pulled back this month, with the pullback being more severe for small caps than big caps. The large-cap S&P 500 Index (SPX) is off its record high by about 1.5%, but the small-cap Russell 2000 Index (RUT) has fallen by 5.5%. This is nothing new in 2017; the small-cap index has lagged behind its big-cap peers all year. Monday’s small loss for the RUT put the index in negative territory for the year, whereas the S&P 500 had gained more than 8% year-to-date.
The popular sentiment is that small-cap stocks are a leading indicator of the economy and the rest of the market. Based on small-cap stock performance thus far in 2017, we should be cautious with our investments. However, contrarian traders know that the prevailing wisdom is often wrong when held up to more scrutiny. This week, I'll look at the actual numbers to see if small-cap underperformance is something we should be wary of.
A Relatively Rare RUT Signal
Since 1979 -- the first year we have Russell 2000 data -- there have been three other years where August saw the Russell 2000 down year-to-date while the S&P 500 was up by at least 4%, per the chart below. The two earliest years, 1998 and 2007, are scary. Both happened right before major market tops. August 1998 still had over a year to go before peaking, but August 2007 was just a couple of months before the top that signaled the beginning of the financial crisis.
The next table shows how those indexes did going forward after those dates. Those returns are all over the map. Stocks exploded higher from August 1998 over the next six months. However, looking closer at those numbers, we see nearly 20% gains for both indexes through the rest of the year. Big-cap stocks slowed down at the start of 1999, and the small-cap stocks fell hard. An argument could be made from those two early signals that small-cap weakness is a sign of stock vulnerability.
The most recent signal bears similarity to this year, with both years the S&P 500 was up around 8% and the Russell 2000 was flat. This would be a counter-argument to the theory that small-cap weakness foreshadows downturns.
The Small-Cap Sweet Spot
For this analysis, I looked at how the rest of the year has played out given the relative strength of the RUT to the SPX. Specifically, going back to 1979, I broke down the rest-of-year returns according to whether the year-to-date relative strength of the Russell 2000 was less than 0.95 (underperformance), above 1.05 (outperformance), or somewhere in between (similar performance).
When small-cap stocks have significantly outperformed through the middle of August, then both indexes have struggled the rest of the year, averaging a return of negative 1.4%. In this instance, small-cap stocks were not the best indicator going forward.
When the small-cap stocks have underperformed the big-cap stocks, like this year, the S&P 500 averages a return of roughly 4%, with 70% of the returns positive. The Russell 2000 averaged a gain of 3.8%, with 60% of the returns positive. These average returns are nothing to be upset about.
The best-case scenario, however, has been when the two indexes are similar in their returns. In this case, both indexes average a higher return with a higher percent positive and lower standard deviation than either of the extreme cases.
