Trading Nation

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

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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 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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