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Are Small-Cap Soldiers Ready to Lead the New Year’s Charge?

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January 12, 2015
Are Small-Cap Soldiers Ready to Lead the New Year’s Charge?

Anyone lucky enough to be gifted with “Stratego” during the holidays?

Okay, I know that’s a bit retro for our screen-obsessed world today. But the old board game with its echoes of the Napoleon-era battlefields of Europe offers an analogy for investors as the new year unfolds.

For much of the past six years, it’s been the large-cap “generals” of the U.S. market—the Standard & Poor’s 500 Index and the Dow, primarily—leading the charge to all-time highs. Meanwhile, the small-cap “soldiers,” as tracked by the Russell 2000 and other measures, have lagged. In 2014, the S&P 500’s gain of 11.4% more than tripled that of the Russell 2000.

Market pros follow the relationship between these categories closely, because when the generals are doing most of the fighting toward higher ground, that may signal trouble for the market’s overall battle plan. So as the U.S. bull market nears its sixth birthday in March, we’re watching to see whether small-cap soldiers start picking up the pace. That may offer clues about how much gas we have left in the tank.

Here are a few factors investors might keep an eye on in the first few months of 2015.

Troop Movements

Market breadth is a technical indicator that measures the number of stocks climbing versus those declining. In a strong bull market, most stocks consistently advance. There are a number of ways to track breadth, including the advance/decline ratio (see figure 1). 

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FIGURE 1: MARCHING ORDERS In early January, the advance/decline ratio for the Russell 2000 fell to the lowest since early December (yellow arrow) amid a broader market slide; the 10-day moving average for the A/D ratio (blue line) also reflected a shorter-term weakness. Source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Generally speaking, if small-caps are going strong, that indicates investors are more willing to take on the elevated risk that often comes with smaller, less-established companies. However, if small-caps are slipping, investors may be losing confidence in overall market direction and may be shifting to the relative safety of large-caps.

It’s All Relative

In late 2014, we saw an interesting development in another technical indicator, relative strength, which compares the performance of a stock or index against the overall market. In the waning days of December, the relative strength of the Russell 2000 against the S&P 500 rose to the highest level in over three months (see figure 2).

 

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FIGURE 2: SHOW OF STRENGTH? In December, relative strength of the Russell 2000 index (yellow arrow) gradually climbed as small-cap stocks closed a gap with the large-cap S&P 500.  Source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Small-cap stocks, along with the rest of the U.S. market, tumbled in the early days of 2015. Nonetheless, indicators such as the A/D ratio and relative strength can still offer valuable insight into possible longer-term market inflection points; the beginnings of a small-cap rally that will close the gap with the large-caps, perhaps?

Time will tell. Signals from the Federal Reserve that the central bank will maintain a go-slow approach to tightening monetary policy has helped boost small-caps. But plenty of other factors lie ahead, including the next quarterly earnings season that begins around now.

NC
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