Stock market analysts talk about an uptrend needing to have the “right kind of leadership.” What they mean by that phrase varies from analyst to analyst, but what I have found is that an uptrend which is not led by small caps is a problematic one. The small-cap stocks which make up the Russell 2000 Index only comprise about 10% of the total market capitalization of the U.S. stock market, but they can play an important role in telling us about the strength of the market. This is because they are terribly sensitive to liquidity conditions, either good or bad.
Small-cap stocks generally lead the way on the upside, and also on the downside. Part of this stems from the inherently higher “beta” of these stocks. If you get a 1% move up or down for the larger-cap Russell 1000 Index, you are likely to see a greater than 1% move in the Russell 2000, because the small caps are more reactive. But sometimes that relationship breaks down, and we see a different, and thus informative, type of behavior.
The simplest way to model the differential in performance over time is with a relative strength ratio, like the one featured in the chart. It is calculated very easily by taking the daily close for the Russell 2000 Index and dividing it by that of the Russell 1000. When the line is moving upward, it says that small caps are outperforming on a relative basis, either by going up faster or going down more slowly. Generally speaking, the overall market does the best during periods when small caps are leading the way higher.
We can also see a benefit from examining this relative strength ratio because it can signal a trend change ahead of that same reversal showing up in overall prices. A trendline break for the relative strength ratio will generally precede the breaking of the equivalent trendline on the price indices.
The problem that we face right now is that the large-cap indices like the Russell 1000, DJIA, and S&P 500 have had a nice surge higher in October 2015, moving to a higher high that is above the September bounce high. But the Russell 2000 Index itself is not confirming that higher high (as of this writing on October 23, 2015), and the relative strength line is pointed decidedly downward. There is no break yet of the declining tops line on this relative strength ratio, and that calls into question the legitimacy of the apparent uptrend in large cap stocks.
It has been possible at certain times in history to see an uptrend persist for a while with large caps leading, and small caps not participating. We saw exactly that back in 1999, when the Internet bubble drew the speculative money into just a few names. They were the right names to push the major averages higher, but the average stock did not participate. That condition was ultimately problematic when the bubble burst in 2000.
If the world’s central banks are going to attempt to prop up the world economy with more quantitative easing (QE), then that should ultimately flow down to the most sensitive small-cap issues, and we can see a change to this current condition. For now, however, the message of the relative strength ratio is that small caps are suffering, and not the place to be.
RELATIVE STRENGTH RATIO OF RUSSELL 2000 TO RUSSELL 1000
Tom McClellan is the editor of The McClellan Market Report newsletter and its companion, Daily Edition. He started that publication in 1995 with his father Sherman McClellan, the co-creator of the McClellan Oscillator, and Tom still has the privilege of working with his father. Tom is a 1982 graduate of West Point, and served 11 years as an Army helicopter pilot before moving to his current career. Tom was named by Timer Digest as the #1 Long-Term Stock Market Timer for both 2011 and 2012. mcoscillator.com
