The Small Cap Canary

NEW YORK (TheStreet) -- If it feels like a strange market environment, that's because it is.

Back in February, I wrote of the risks in the small-cap indexes (Russell 2000) and the potential for a massive rotation into large caps to begin. Small caps had been outperforming large caps for over 15 years, I argued, leaving their shares priced for perfection and trading at a significant premium to large caps.

By some measures, small caps were trading at their highest valuations in history. While I expressed this concern, I would not have guessed what would happen next.

In March and April, for the first time in history, we saw consecutive monthly declines in the Russell 2000 Index while the S&P 500 Index posted consecutive monthly gains. You read that correctly. This divergence had never occurred before in the history of these two indexes.


From its peak in early March to its low in early May, the Russell 2000 dropped over 10%, giving back all of its outperformance from the beginning of 2013. Meanwhile, the S&P 500 was relatively unscathed during this decline, emboldening investors to pile into large-cap shares and drive them to all-time highs in yesterday's trading.

The question for investors here is what this historic divergence is telling us, if anything, about the health of the equity markets. With the S&P 500 at new highs, for now most investors seem to be working with the assumption that the small-cap divergence is actually bullish. Their argument is simply that this is a "healthy rotation" that was bound to happen given the long period of outperformance in small caps.

The less sanguine interpretation is that the smart money is subtly moving out of small caps into larger, more defensive issues because they are looking ahead to more troubling times.

Indeed, this defensive behavior is being exhibited in other areas of the market as long-duration bonds have been bid higher, high momentum growth names have been crushed and consumer-discretionary stocks have been lagging. If the weakness were just in small caps, one could look past it as an isolated issue, but alas, it is not.

Only time will tell which interpretation is correct, but we cannot rule out the possibility that small-cap weakness is a canary in the coal mine.

Therefore, unless small caps begin to recover and the defensive behavior in other markets starts to improve, these new highs in the large-cap indexes should at the very least be treated with caution.

That is especially true given the change in the Federal Reserve's policy and the possibility that market participants will front run the Fed in selling before the end of this round of quantitative easing, a concept I wrote about last month.

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At the time of publication, the author had no position in any of the funds mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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