Small stocks signal weakness

The lagging performance of the riskiest, most sensitive issues suggests a pullback is in order.

By Anthony Mirhaydari Sep 16, 2010 4:08PM

MirhaydariOne of my favorite indicators of the health of the stock market compares the performance of the smallest, riskiest equities to the largest, most well known issues. And right now, with the small stocks in the Russell 2000 ($RUT) badly lagging the mega-cap stocks in the Dow Jones Industrial Average ($INDU), this is yet another sign that the rebound rally out of the August lows is nearing its end. (For more, see my last blog post here.)

 

Frequently, at turning points, you'll see small cap stocks lead the way. Although there is no way to test the idea, my hunch is that savvy Wall Street pros are moving in and out of smaller, fast moving stocks ahead of major market moves while at the same time holding in stasis more closely followed indices like the Dow. Then, once they are ready, they withdraw support for the mega-cap stocks, and the whole house of cards comes tumbling down.

 

Thursday's trading action suggests that's exactly what's happening now. The Russell 2000 lost 0.7% while the Dow gained 0.2%. Here's what you need to know.

 

Small vs Large

 

Check out the chart above. The top pane shows the relative performance of the Russell 2000 versus the Dow. The middle pane is the 14-day stochastic of the small cap vs. large cap relationship. And the lower pane is simply the S&P 500 index.

 

As you can see, not only are small caps stuck in a channel of long-term underperformance relative to large caps (blue dashed line) but they are now once again overbought on a short-term basis (middle pane). And like the late July pullback in small stocks that led to the early August correction for the broad market -- I think the current situation will be resolved to the downside.

 

And if that's the case, investors would be wise to -- at the very least -- hold off on new purchases until the situation clears.

 

To be fair, this indicator isn't fool proof. It did give false signals this spring during the run up to the April high -- as large cap stocks took the reins and pushed the market to new highs despite the lagging performance of their smaller brethren. While a repeat performance is certainly possible now, other evidence including market breadth suggest a correction is needed to encourage new buyers.

 

Disclosure: The author does not own or control a position in any  company mentioned.

 

Be sure to check out Anthony's new investment advisory service, the Edge, which is launching this month. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below. 

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