Do Small Cap Stocks Know Something We Don’t?

The Wall Street Journal reported this week the small-cap Russell 2000 closed below its 200-day small capsmoving average on Tuesday for the first time since November 2012, snapping a streak of 363 trading days above the closely watched technical indicator. That marked the index’s third longest streak dating back to its inception in 1978.  While history is not always an accurate predictor of the future, it can sometimes serve as a reference point, particularly when it comes to market cycles.  This technical indicator (the 200-day moving average) is often used as a benchmark to gauge a market’s long-term trend. When a stock or index trades above the 200-day, it is in an uptrend. But when it falls below, it is in a downtrend that could lead to more declines.

The Russell 2000 dropped 1.6% Tuesday to 1108. It is down 7.1% from the record high hit in March and down almost 5% year-to-date. As the Wall Street Journal reports, “about half of the Russell’s components are down 20% or more from their respective 52-high weeks. Some 80% of them are down at least 10% from their respective highs, showing how the declines across small-cap stocks have been broad and deep this year.  The S&P 500, meanwhile, remains stuck in a broad trading range. It is up just over 1% for the year and approximately 1% below its record high. Over the past several months it has traded roughly between 1820 and 1890.  This sideways movement is very different than last year when the S&P 500 surged 30% to record levels. The Russell 2000 did even better last year, up 37%.

Late last year the decision was made to lighten small cap exposure in client portfolios.  This was based primarily on two factors.  First, the category had shown steady, positive performance for almost 5 years beginning in March 2009.  Second, small cap investments seemed overvalued relative to past years. Knowing the category is often a harbinger of future market trends, positions were reduced relative to standard target allocations.  As small cap investments continue to fluctuate, we will watch for opportunities as well as indicators suggesting further declines.  A single category should never be relied on to predict the future of the broader market, but it does make you wonder whether small cap stocks know something we don’t.