Small Caps Continue To Power Bull Market

Since 1999 the small cap sector has been leading its larger cap cousins in performance. This long term trend has reasserted itself once again. Here’s a chart of the Russell 2000 divided by the S&P 500 index:

Small cap stocks were affected by the recent correction but slightly less so, falling about 5.9% peak to trough. The strong breadth that we’ve observed for some time is by a large part thanks to this portion of the stock market.

As a group, small caps are also more likely to be domestic focused companies (barring a few exceptions like the trendy Chinese IPOs we’ve seen recently). So the strength in small caps is also a vote of confidence in the US economy and its ability to birth mega-corporations.

On a relative basis, the Russell 2000 index is now performing better than the S&P 500 large cap index since 1986. This makes it difficult to argue against the bull market. The only argument against the bull market based on this outperformance may be that it is a sign of exuberance and risk seeking.

This is because large cap stocks are more diversified (either by market or geography) and perceived to be less risky. However, the level of preference for small cap stocks has been persistent. As well, I don’t think it is at a level that can be dangerous yet.

Having said that, we must note that this relative outperformance is no guarantee of a continuing bull market. In the heady days of the late 1990’s when there was a general buzz around equities and equity trading, small caps were performing horribly (in relation to large caps).

What this outperformance tells us is that the bull market is not contained within a small section of the stock market. And as long as the uptrend is supported by a wide and varied constituency, it has a much higher chance of continuing.

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One Response to Small Caps Continue To Power Bull Market

  1. Adrian Wu says:

    If the argument is that the high small caps : large caps ratio is a bullish sign that the bull market will continue, is the opposite also true ? When the SML:SPX ratio was hitting bottom at 0.27 in March 2009, should you have made the argument that the low ratio was a bearish sign that the bear market would continue ? The fact that the markets rallied almost 100% for the next two years actually tells us the opposite conclusion is correct: A low ratio is bullish (extreme risk averse behavior), and a high ratio is bearish (extreme risk seeking behavior). The ratio cannot go in one direction forever and eventually reverts to the mean when it hits an extreme, and the ratio now being higher than any time during the last 20 years looks to me to be very ominous indeed.

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