Small-Cap Weakness Puts Market History in Focus

Small cap stocks have drastically underperformed large cap stocks over the past couple of months. The small cap Russell 2000 Index (RUT) and large cap S&P 500 Index (SPX) both hit all-time highs in mid-August, but their paths have diverged since then. The RUT has trended steadily lower and sits more than 8% below its high, while the SPX hit a new high just last week and remains very close to that level.

This week, I’ll look at the historical data when small caps underperformed by such a wide margin against large caps. Has this been a bullish or bearish indicator for stocks in general and has one index stood out against the other?

RUT Two-Month Relative Strength

The two-month relative strength of the RUT versus the SPX is at 0.91. It’s an extremely low level which we haven’t seen since May of 2023.             

I looked at RUT and SPX data going back to 1985. The first table below shows how the SPX has performed going forward when the RUT has significantly underperformed the SPX over the prior two months. Specifically, it’s the returns after the RUT two-month relative strength is below 0.95. The second table shows the opposite. It’s when the RUT has severely outperformed the SPX with a two-month relative strength above 1.05.

The recent RUT underperformance has been a bullish sign for the SPX. Over the next three months, the SPX averaged a 5% return with 76% of the returns positively when the RUT has drastically underperformed over the previous two months.

When small caps significantly outperformed the large caps over two months, the SPX has averaged a return of less than a percent over the next three months with 68% of returns positive. At each time frame, from two weeks to one year, huge small cap underperformance has led to better returns compared to when small caps drastically outperform.

As far as which index to buy, it barely matters. The SPX beats the RUT a little over 50% of the time, but both indexes have performed very well with similar returns when the RUT relative strength was below 0.95.

For completeness, the tables below show the SPX and RUT forward returns when the RUT two-month relative strength fell between those two extremes.

Near All-Time Highs

Given that small caps significantly underperformed large caps, I broke down those returns by whether it occurred with the SPX within one percent of its all-time high (our current situation) or farther off its high.

There’s bad news and good news. The bad news is that the SPX outperformance disappears. The large caps underperform in the short term (out to a month), and then after that, the returns are in line with their usual returns. The good news is it becomes clear which index performed better; the large caps. The SPX beat the RUT 73% of the time over the next three months in these situations and over 80% of the time over the next year.

These next tables show the RUT after the index underperformed the SPX over the previous two months. The first table shows the returns when the SPX was near a high (our current situation). The RUT has underperformed in these situations all the time frames.

Current Environment Filter

To get the dates below, I found times that align with our current environment. I’m only considering the first signal over a three-month period. Each of the dates met these four criteria:

1. RUT two-month relative strength is less than 0.95.

2. The SPX is within a percent of its all-time high.

3. The SPX is up over the past two months.

4. The RUT is down at least 5% over the past 2 months.

We last saw this setup in the second half of 2021, which was a poor time to be long stocks. Both indexes lost over 20% over the next six months after the last signal date of 12/16/2021.  

We also saw this setup in mid-2014, in which the market did fine going forward. The only other signals occurred in the late 1990’s. The signal in March of 1999 saw huge gains over the next year in small cap stocks (over 50%!), which marked the top before the dotcom bust.

Implications

Over the past couple of months, the RUT small cap index has tanked while the large cap SPX trades near all-time highs. Historically, when the RUT underperforms by this amount over a two-month period, stocks, whether large caps or small caps, tended to do very well going forward from two weeks to a year.

However, when the underperformance of small caps occurs and the large caps are at highs, the large cap stocks underperformed their usual return over the short term and matched their typical return in the longer term (three months to a year). Also, in these situations, the large cap stocks were preferable to small cap stocks.