Small-Cap Weakness Latest Threat to Stock Market Rally

Weakness in small-cap shares is presenting the latest challenge to the stock market's protracted rally as the key leadership group has underperformed over the past month.

A trader holds his head in his hand on the floor of the New York Stock Exchange in New York City
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A trader holds his head in his hand on the floor of the New York Stock Exchange in New York City

Along with cyclical areas like technology and financials, companies with market capitalization between $300 million and $2 billion often determine market performance. Small-caps are considered a good gauge to judge economic health at the grassroots level.

But after a solid January, the group has waned — with the Russell 2000 benchmark index still posting a positive February return in the 2.3 percent range but well behind larger indexes such as the Standard & Poor's 500, which rose 4 percent.

"Small caps are cyclical in nature, and typically perform better during market rallies," Paul Hickey at Bespoke Investment Group, said in a recent note. "They haven't been rallying recently, which should be cause for concern for market bulls."

Bespoke points out that the trend has been more noticeable over the past two weeks, when the Russell fell as many days as the S&P 500 rose.

With a bull-market rally that began in October at stake, market pros worry that the small-cap pullback combined with weakness in the Dow transportation stocks— a key component in Dow Theory — form yet another sign that the market is losing steam.

"While the media is filled with headlines of Dow 13,000 and Nasdaq 3,000, not everything in the equity market is coming up roses," David Rosenberg, senior economist and strategist at Gluskin Sheff in Toronto, said in a note.

"In a 'risk-on' environment, the riskier small caps should be outperforming the stodgy large-caps, and in a backdrop of supposedly better economic growth, the ultra-economic sensitive transportation stocks should be — but aren’t — making new highs or at least outperforming," he added.

No doubt, the turnabout in small-caps has been pronounced.

From the time the cyclical bull began on Oct. 3, the Russell 2000 surged 36.4 percent, dwarfing the S&P 500's 21.4 percent run through Feb. 3.

Since then, though, it's been a completely different story, with the Russell down 2.7 percent and the S&P up 2.4 percent. The primary exchange-traded fund that tracks the smallcaps — the iShares Russell 2000 Index — has underperformed the SPDRS&P 500 ETF Trust on 16 of the past 19 trading days, according to institutional trading firm BTIG.

True to form, the Russell again badly underperformed the other averages during Friday's stock marketdrop.

Not everyone is so worried, though,

Lori Calvasina, small-cap analyst at Credit Suisse, said she still likes the small-cap space, favoring some of the cyclical areas in particular.

"If you look on a sector-by-sector basis, price-to-book and price-to-sales, your best-performing sectors in small-caps are materials, industrials and technology," Calvasina said in an interview. "They all look attractive valued in small- relative to large-cap."

One of the primary worries over small-caps is valuation.

The Russell is trading at about 15 and a half times earnings, which looks rich compared to the S&P 500 stocks.

But Calvasina said the current P/E is only slightly ahead of its historical 15.4 and well away from the mid-17s where it traded last year.

"Even though prices on the Russell are starting to get back, the valuation multiples look like they still have a lot of room to run," she said.

With analysts beginning to kick up their earningsforecasts on small caps, the group's weakness in February could be another false-alarm for the impending correction.

"We've been seeing some incremental activity in terms of analysts taking numbers up," Calvasina said. "That's usually a good sign for the sector, and the markets, when that happens."