Traders work on the floor of at the closing bell of the Dow Industrial Average at the New York Stock Exchange on October 31, 2018 in New York.
Bryan R. Smith | AFP | Getty Images
The performance gap between small caps and large caps is widening to historic lows, a trend seen during times of economic stress and investor caution, possibly signaling something worse with the economy could be coming.
The small-cap benchmark Russell 2000 is in correction territory, trading nearly 14% below its 52-week intraday high in August 2018. Tthe S&P 500 is only off by 4% from its high. Something doesn’t add up.
“Large cap outperformance of small caps is reaching historic levels, and is noticeably a function of global investor caution,” Raymond James’ Tavis McCourt said in a note to clients. “This is a classic liquidity premium, and is noticeable in all recent periods of global economic fear.”
When small and mid-cap stocks start underperforming large stocks at this magnitude, it usually means investors are worried, so they are huddling in big names that are easy to trade and shedding smaller companies generally considered riskier, especially if they believe there’s a recession ahead.
“The Russell 2000 is probably a better measure of U.S. investor psychology,” said McCourt.
This occurred during past soft patches since the financial crisis. Ultimately, this has been resolved with risk appetite increasing and investors going back into smaller stocks. Small-cap stock performance relative to large-caps is now near its lowest level since the financial crisis, so if smaller stocks don’t bounce back, it could signal a bigger crisis than those that have occurred the last 10 years.
Earlier this year, small caps had been having the best start to a year since 1987. However, the confluence of the U.S. China trade war and global interest rates at all-time lows spurred investor worry about the global economy, sending small caps to fresh lows.
“Smaller stocks and value stocks tend to work when you start to see a recovery in the profits backdrop,” said Jill Carey Hall, Bank of American Merrill Lynch U.S. equity strategist. “The valuation looks compelling but a lot of the data hasn’t turned yet.”