Trading Nation

Small caps just hit a record, and here’s why there could be even more gains

Trading Nation: Does valuation matter?

The answer to whether the rally in large-cap companies will continue may be found in one chart — of small-caps.

The Russell 2000 small-cap index hit a record high on Tuesday, which is very good news according to Oppenheimer's head of technical analysis Ari Wald.

Wald says that the small-caps are providing a "tell" on the overall momentum of the market. He notes that the small-cap index has traded in a range since December and "never really broke down," holding support at the 1,430 level and resuming a leadership role this week.

"Late in the cycle, what will happen is that you'll see internal breadth start to narrow, fewer stocks start to move higher, and it masks weakness under the surface. So it might look like it's performing well but small-caps are beginning to break down. That's not happening," he said Tuesday in a phone interview with CNBC.

In fact, the Russell 2000 has worked off previously overbought conditions" and is now headed higher after trading in this range since December, Wald noted. This marks healthy internal breadth — the number of companies rallying relative to the number declining — and is indicative of a broader bull market.

Wald's comments came after Monday's strong performance for equities across the board, in which the Dow Jones industrial average, and Nasdaq composite and Russell 2000 posted their best days in over a month. The major indexes extended their gains in Tuesday.

"We're seeing some signs of it inflecting higher with the more recent turn in equity prices. And as it turns higher, and we think sets up for new highs, we think participation broadens in the market, and we think this helps lengthen the duration of the equity cycle," Wald said Monday on CNBC's "Power Lunch."

On a more fundamental level, valuations appear stretched and investors ought to be cautious, according to Chad Morganlander of Washington Crossing Advisors.

"When you look at a forward-looking multiple, we're expecting about a 17.5 times [price-to-earnings] multiple at this point, and that's far in excess of its historic average of the 10 years of 14 times [price-to-earnings]," he said.

Indeed, elevated stock market valuations reflect investors' preferences for equities in the "existing slow growth, low inflation, and suppressed bond market yield environment," according to a recent S&P Global Market Intelligence report.

The ratio of gross domestic product to market capitalization, too, is elevated from historic patterns, Morganlander continued.

"So we would be somewhat more balanced within one's portfolio when it comes to the S&P. Over the next 12 months we're looking at a 5 to 6 percent total return, but again, I think it's time to be somewhat more cautious," he said.

He concluded: "I think the overall market is quite vulnerable at this point."

This theme of historically high valuations was precisely what veteran hedge fund manager Paul Tudor Jones reportedly pointed to recently in a closed-door meeting with Goldman Sachs.

Jones reportedly said the high value of total stock market capitalization relative to the size of the should be "terrifying" to central bankers, namely Federal Reserve chair Janet Yellen.