Does the small-cap underperformance predict large-cap pain?

Small-cap stocks have fallen behind in the recent rally, with the Russell 2000 down more than 3 percent year to date even after the S&P 500 has turned positive again for the year. And the lag could mean it's time to buy protection on large-cap stocks, according to one trader.

Stacey Gilbert, head of derivative strategy at Susquehanna, said protection pricing for small-cap stocks has reached one of its highest levels over the past year. And while that isn't a definitive indicator of pain for large-cap stocks, it could still be a troubling sign, she said.

"There's no real evidence to say that it's predictable that if large-cap is outperforming small-cap you should sell your S&P 500 here," Gilbert said Friday on "Trading Nation." "But you can't have a sustained rally in the S&P 500 without some sort of participation with the Russell."

Gilbert said some large-cap protection plays in the options market look particularly cheap right now, including out-of-the-money put spreads.

"Given this rally here and given we're not seeing small-cap participation, we've suggested to clients we really like this protection play," she said.

Another concern is the lack of response in small-cap stocks to a stronger U.S. dollar, said Rich Ross of Evercore ISI.

As the dollar has strengthened, the currency move would tend to boost U.S.-focused names such as small-caps stocks. However, it's the large-cap stocks that have led the rally, particularly those that reported impressive earnings beats.

"I think a lot of it has to do with the fact that investors are moving back in slowly, trying to repair that fragile psychology so they're gravitating toward those large-cap stocks," Ross said Friday. "They're eschewing the semi-higher risk, higher beta of the Russell 2000 and that's an issue for the Russell here."

And from a technical perspective, Ross said that the Russell 2000 has clearly diverged while struggling to return to its 50-day moving average, while the S&P has climbed back above both its 50-day and 200-day moving averages.

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Trading Nation is a multimedia financial news program that shows investors and traders how to use the news of the day to their advantage. This is where experts from across the financial world – including macro strategists, technical analysts, stock-pickers, and traders who specialize in options, currencies, and fixed income – come together to find the best ways to capitalize on recent developments in the market. Trading Nation: Where headlines become opportunities.

Michael Santoli

Michael Santoli joined CNBC in October 2015 as a Senior Markets Commentator, based at the network's Global Headquarters in Englewood Cliffs, N.J.  Santoli brings his extensive markets expertise to CNBC's Business Day programming, with a regular appearance on CNBC's “Closing Bell (M-F, 3PM-5PM ET).   In addition, he contributes to CNBCand CNBC PRO, writing regular articles and creating original digital videos.

Previously, Santoli was a Senior Columnist at Yahoo Finance, where he wrote analysis and commentary on the stock market, corporate news and the economy. He also appeared on Yahoo Finance video programs, where he offered insights on the most important business stories of the day, and was a regular contributor to CNBC and other networks.

Follow Michael Santoli on Twitter @michaelsantoli

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