There is a heated debate between the large-cap and the small-cap stock markets. Some investors say the current environment favors large-capitalization stocks. Others believe the smaller companies will excel in a recovering economy.
It has been predominately a large-cap stock market rally this year, specifically in the large technology companies and the large-cap stay-at-home plays. However, during October, the small-caps have begun to show early signs of outperforming its larger-cap counterparts. At the current pace, the small-caps poised for its best month of relative performance in over three years.
So, what drives the small-caps?
One of the primary headwinds facing the small-caps and the reason for the underperformance is the sector composition. The Russell 2000 Index (RUT or IWM ETF) and S&P 400 Small-Cap (SML) are weighted toward two sectors, Financials (14.89% of the RUT) and Healthcare (20.69% of the RUT). Although Healthcare is a secular growth sector, it has become increasingly volatile ahead of the November presidential election. Financials continue to struggle with the continued low historical interest rates. On the other hand, the large-caps are weighted toward the Information Technology sector (27.99% of SPX) and the Communication Services sector (10.60% of SPX).
From a technical perspective, there are mixed signals generated from the large-cap versus small-cap, mid-cap, and micro-cap studies. For instance, the Relative Rotation Graph (RRG) daily study over the past 30-trading days coinciding with the recent peak in the stock market (9/2/20) suggest there are near-term rotations that favor the small-cap, mid-cap, and micro-cap stocks. The RRG weekly study over the past 6-weeks also hints of relative price and momentum strength trends tilting toward the small-cap, mid-cap, and micro-cap areas. Surprisingly, since the recent market turmoil 9/2/20 peak, the relative performance analysis shows the micro-caps (IWC +2.94%) outperforming even the mid-caps (MID +0.91%) and the small-cap (IWM +2.05%). During this same period, most large-caps indexes dramatically underperformed (INDU -2.02%, NASDAQ Composite Index -2.39%, SPX -2.57%, and OEX -3.60%).
Many believe small-cap tends to outperform their peers during good times when the economy is humming, and the stock market is in strong bull rallies. Similarly, many others believe that it is an omen of difficult times ahead when small-caps underperforms the large-cap markets as this warns of a weakening domestic economy as investors tend to favor larger, well-capitalized, and liquid blue-chip stocks. However, history has shown that this is not entirely true. Small-caps tend to relatively underperform their larger market-cap peers during long-term structural stock market bull trends. For example, a simple ratio analysis between small-caps and large-caps dating back to the 1930s show the small-caps tend to underperform large-caps during on a relative basis during secular bull market trends (i.e., 1949-1965, 1982-2000, and the current 2013-present).
Although the small-caps, mid-caps, and micro-caps are improving and may indeed continue to outperform on a near-to-medium term basis, they still need further technical work to confirm longer-term leadership roles. It is constructive the RRG and the relative strength studies have improved, but require convincingly technical breakouts above pivotal resistances to solidify the start of an outperformance cycle, at least from a sustainable intermediate-to-longer term perspective. For the SML, key initial resistance resides at 937.09 (8/11/20 high), and above this to 990-1,006/1,018 (2/24/20 gap down and the Aug 2018 downtrend), and then to 1,046.34 (1/17/20 high). For IWM, key resistance remains at 168.20-168.49 (Aug 2018 and Jan 2020 all-time highs).
We will continue to closely monitor the rotations between small-caps versus large-caps to help identify new leadership sectors and names but importantly, to gauge the sustainability of the 2013-present structural bull trend in U.S. stocks. In the meantime, we have updated the list of the top 20 SCTR ranked stocks from the large-cap, mid-cap, and small-cap universe.