Study: large caps underperformance vs. small caps is bullish for stocks


As you probably already know, large cap stocks (Dow Jones index) have underperformed small cap stocks (Russell 2000 index) in 2018.

Here’s the Dow:Russell ratio. Notice how this ratio fell for 5 months in a row from February – June 2018 (i.e. Dow underperformed the Russell for 5 consecutive months).

This is a medium-long term bullish sign for the U.S. stock market. Persistent underperformance from large caps only happens during bull markets.
Large caps tend to outperform during bear markets or at the very top of bull markets. This is because large cap stocks are defensive stocks while small cap stocks are riskier stocks. Investors tend to shift into defensive stocks during bear markets. Hence, large caps (Dow) fall less than small caps during bear markets.

The Dow Jones has underperformed the Russell 2000 for 5 consecutive months from February-June 2018. Here’s what happens next to the S&P 500 when this happens (historically).

Here’s what happens next to the Dow when the Dow underperforms the Russell for 5 months in a row.

Here’s what happens next to the Russell when the Dow underperforms the Russell for 5 months in a row.

Click here to download the data in Excel

Conclusion

As you can see, the U.S. stock market tends to go up in the medium-long term after large caps (Dow) consistently underperforms small caps (Russell 2000).
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