Small-cap stocks are lagging behind the S&P 500, is this another recession warning?

small-cap stocks

Small-cap stocks exhibit a wider range of volatility in comparison to their larger-cap cousins, and as a group is seen as a potential canary-in-the-coalmine so to speak for the markets at large. If small-cap stocks are outperforming major indexes, that’s a good sign, but if the inverse is true, some experts become worried.

That’s exactly what has been happening for a while now, and amidst other warnings signs such as the recent return of the inverted U.S. yield curves, worries certainly haven’t been higher than they are now.

The S&P 500 has been one of the strongest market averages over the past few months. During the past quarter leading up to its all-time high on July 26th, it returned an impressive 3.4 percent (assuming dividends got reinvested).

In comparison, the Russell 2000 index, the main benchmark or the small-cap sector, fell by 0.8 percent. Another significant index, the iShare Micro-Cap ETF, also fell by 3.4 percent during the same time period.

What makes this all the more worrying is the fact that preceding some of the major market tops in the past, small-cap stocks ended up lagging behind the large-cap sector, effectively predicting a major turnaround. This proved to be the case most recently in October 2007 before the financial crisis hit and many investment banks went bankrupt in a flash.

While this is worrying to many, there have been some specific situations where this was the other way around. In the internet bubble, for instance, the three months leading up to March 24th, 2000 saw the Russe index rise by 19 percent whereas the S&P 500 rose by only 5.1 percent.

While this makes sense considering that internet stocks, for the most part, were small, start-ups that later ballooned to a larger size, the question of just how accurate of a predictor small caps are in forecasting an upcoming recession might be more complicated than it first appeared.

According to one article published on MarketWatch, analyst and author Mark Hulbert looked at the strength of the small-cap sector up to three-months before every single bull-market top since 1926. Overall, he found that out of the 29 bull markets since 1926, small-cap stocks outperformed large caps in 15 cases and fell behind their larger-cap cousins in 14 of them. While this might seem to debunk the idea that small-cap stocks are a reliable predictor, other analysts disagree.

Hayes Martin, president of Market Extremes, an investment firm that specializes in finding major market turning points, went on to say that the divergence between small-caps and large-caps might not show up on just a three-month timeframe. “Small-cap stocks can diverge for very extended periods before major market tops,” he stated. This would instead suggest that you can’t really time the markets based on how small caps have been doing, but rather that they are a general sign that a turnaround could be on the horizon on an unspecified timeframe.

One indicator that makes more sense in his eyes is to compare the ratio of the regular S&P 500 with its equal-weighted version (RSP). The difference comes from how the two indexes weight each stock. The regular S&P 500 could see a situation where a handful of mega-caps in the index are propping it up artificially high while the remaining stocks are falling. In this case, however, the equal-weighted version would fall.

At present, both the S&P 500 and the equal-weighted version hit record highs in late July, meaning that there isn’t a significant divergence among the large-cap and mega-cap stocks at the moment. This would suggest that a major downturn isn’t imminent, and the different between small-caps and large-caps as a whole isn’t large enough to start pulling down the markets at large.

While it’s hard to predict exactly when a recession will take place or just how severe it will be, what almost everyone agrees on is that a bear market is long overdue.