The Major Divergence Between Small Caps and Large Caps

Since that surge on Monday this market is really scuffling and providing very little opportunities from either the long or short side unless you are an extremely short term oriented daytrader sort. We’re essentially in a holding pattern circling the airport… it is just unclear if this is the correct airport.

I want to show quite an interesting divergence, one we have been talking about for 6 weeks…. and that is the lagging nature of the small caps versus the large caps. While the DJIA, S&P 500, and NASDAQ get all the publicity, the Russell indexes are quite important and something I look at a lot.

There are 2 major indexes, the Russell 1000 (RUI) and Russell 2000 (RUT), both components of the Russell 3000 (RUA). The Russell 3000 covers 98% of the market capitalization in the stock market so it’s effectively the market (there is an even broader measure out there called the Wilshire 5000, with the bottom 2000 stocks being very small). The Russell 3000 can be broken cleanly in 2 pieces, the largest 1000(ish) go into the Russell 1000 and the smaller 2000(ish) go into the Russell 2000. I measure the fund performance against the Russell 1000 because it is broader than the S&P 500, with the bottom half of the Russell index representing the type of stocks we spend a lot of time in ($3B, $4B, $5B type of market capitalizations).

Either way, when we compare and contrast the charts we can see one the issues that has been flagged in this market for the past 6 weeks; a major divergence between larger cap stocks (Russell 1000) and smaller cap stocks (Russell 2000).

Russell 1000

Russell 2000

The Russell 1000 looks almost identical to the charts of the NASDAQ and S&P 500. Making newer highs, pulling back to support and just charging along – looks fine. The Russell 2000 on the other hand has a troublesome chart. For those who follow technical analysis you see a very obvious “double top” over the past 3 months, at 625. Not to mention after breaking through the 50 day moving average in the past week, it has now broken right back below it. These are 2 quite bearish situations.

The implications here is this market is being led by large caps, and the rally is getting more and more narrow. A market led by large caps is not bad nor good; I am ambivalent about that. But a narrowing rally is not good. That said, we noticed this about a month ago and thus far it has not mattered. Volume is quite poor in the markets as well, and has been for months – again a warning sign that has not mattered. Personally with the volume situation, this seems like a market dominated by professionals as the retail investor is mostly crowded out, liquidating old investments to survive in this economy, or sticking to bond funds. With 50-60% of trading just between 1 computer and the next in milliseconds, it appears those algorithms are a lot more interested in liquid large caps than small caps. Can this divergence keep going? Sure – why not. But in the old market this action in the Russell 2000 would be a big red warning sign. In this new paradigm market? Who knows anymore.

About Mark Hanna 543 Articles

Affiliation: Hanna Capital, LLC

Mark Hanna is President and Owner of Hanna Capital, LLC, a registered investment advisory firm. Mark has been a follower of markets since the late 80s, with a focus on individual equities since the mid 90s. He has been a well known commentator in the financial blogosphere for the past 5 years, following a career in corpoporate finance and accounting. Mark attended the University of Michigan where he graduated with a degree in Economics.

As an avid reader, Market Montage is the personal blogging site for Mark to share his views on economics, markets, and the like. Occasional cynicism and wit shall be deployed in his postings.

Follow Mark on Twitter @fundmyfund.

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