What happens when small cap underperforms large cap

There have been a lot of concerns about “weak” market breadth recently. For example, the small cap index Russell 2000 has significantly underperformed the S&P 500, the Dow, and NASDAQ since the beginning of 2017.
Here is the year-to-date performance for these 4 indices.

Let’s see what happens historically when RUT (the Russell 2000) lags the S&P’s gains by more than 5% on a 5 month basis (105 trading days). A 5% gap is a significant difference for a slow moving market like U.S. equties.
*We’re going to ignore the difference between the NASDAQ and RUT. The NASDAQ frequently outperformed all other indices during the dot-com bubble. Hence, the gap between NASDAQ and other indices has no historical significance.
*We’re only using CLOSE prices.
*We’re only looking at bull market cases..

Bottom line

The small cap index’s underperformance is irrelevant.

  1. Sometimes RUT’s underperformance was followed by a multi-month rally for the S&P.
  2. Sometimes RUT’s underperformance was soon followed by a pullback.
  3. Sometimes RUT’s underperformance was immediately followed by a small or a significant correction.

In other words, weak breadth isn’t a problem. A rally that’s led by large cap stocks isn’t “bearish”.
Here are the historical cases.

December 3, 2014

The S&P and RUT diverged by early-December 2014. The S&P then made a 5.1% pullback before consolidating in December 2014 and January 2015.
The next significant correction began in May 2015.

August 22, 2014

The S&P was flat for virtually one month before its next small correction began in mid-September 2014.

June 5, 2014

The S&P continued to rally for more than 1.5 months before it began a 4.3% pullback in late-July.

November 27, 2009

After this divergence, the S&P rallied for more than 1.5 months before it made a small correction in late-January 2010.

July 23, 2007

This divergence became apparent just before the S&P began a rather large “small correction” (as defined by our model). Unlike the previous cases, this divergence caught the S&P’s exact top before the correction.

November 5, 1999

After this divergence, the S&P rallied for almost 2 months before making a 10.3% small correction in January 2000.

December 31, 1998

The S&P continued to soar for 4.5 months after this divergence. The eventual 7.3% small correction in May 1999 didn’t even bring the S&P back down to its price on December 31, 1998.

January 27, 1998

The S&P soared over the next 2 months. Then it consolidated from April-May, and soared again from June-July. Then it made a “significant correction”. The significant correction barely brought the S&P back down to its price on January 27, 1998.

November 14, 1996

The S&P soared for 3 more months before beginning a 10.2% “small correction” in February 1997. The small correction just brought the S&P down to its November 14, 1996 levels.

September 18, 1996

The S&P soared for 5 more months before making a small correction in February 1997.

December 18, 1995

1995 was a terrific year for bullish stock market investors. The S&P consolidated throughout the rest of December before making a 4.3% pullback. Then it soared again in January-February 1996 before making a small correction.

February 22, 1995

The S&P and Russell diverged at the beginning of a MASSIVE rally. The S&P soared throughout all of 1995 and did not make a correction that year.

August 29, 1994

The divergence signal came out just before the S&P made a 7.2% small correction from August 31 – September 12, 1994.

July 19, 1990

This divergence occurred just as the S&P was beginning its significant correction of 1990.
*Our model predicted this significant correction with stunning accuracy (off by just 2 days from the top). This was one of the model’s best predictions.

November 27, 1989

The S&P rallied for 1 more month before it made a rather big 11.3% “small correction” in January 1990.

July 27, 1989

The S&P soared 2.5 months before making a small correction in October 1989 (see above chart).

January 9, 1989

Like the 1995 case, the S&P diverged in January 1989 and then soared throughout most of the year. The S&P’s next small correction was in October 1989.

October 21, 1988

This was the exact top before the S&P made a 7.4% small correction.

March 17, 1988

This was the exact top before the S&P began a 8.7% small correction.

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