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Can Small Caps Help Predict Market Direction?

Small-cap stocks can often be used to make predictions on the future direction of the overall market.

Traders often look for an edge in the market. When broad market indices are down, traders often look to subcategories, such as industry groups and sectors, or growth stocks versus value stocks, in search of outperforming segments. Performance within and among these various segments can vary greatly.

This is also true of “large-cap” stocks versus “small-cap” stocks. In this case, “cap” is short for “market capitalization,” which is the price of the stock multiplied by the number of shares outstanding. Established stocks with many millions of shares are typically deemed large-cap while others, often with lower prices or fewer shares outstanding, are generally considered small-cap. During certain market conditions, large-cap stocks may outperform small-cap stocks, and vice versa. One popular notion is that small-cap stocks can be used to indicate the potential future direction of the overall market.

Two ways to use small cap stocks as an indicator of potential market action

Method #1: Spotting a divergence

In a healthy market environment, most market segments should be performing well. However, chart-based traders might look to see if there is a noticeable difference between the price action of small-cap stocks versus that of large-cap stocks. One thing that traders commonly look for is a “bearish divergence,” a period in which large-caps are reaching new highs, while small-caps are not. Many believe that this scenario is an early warning sign, not just for small-cap stocks, but also for stocks in general.

The Russell 1000 Index ($RUI) tracks the 1000 largest companies within the broad-based Russell 3000 Index ($RUA). Alternatively, the Russell 2000 Index ($RUT) tracks the 2000 smallest companies within the Russell 3000 Index. Figure 1 displays monthly bar charts for both $RUI, on top, and $RUT, on the bottom.

Figure 1 – Bearish divergences for small-caps (lower chart) appearing just before notable market declines in both small-cap and large-cap stocks
Figure 1 shows three occasions where large-cap stocks made a new high that was not confirmed by small-cap stocks. In each case, both segments, as well as the market as a whole, soon suffered a significant price decline. These are examples of a bearish divergence seeming to forecast imminent overall market weakness.

Method #2: Tracking relative performance

While some technical traders primarily rely on chart-based technical analysis, others focus more on quantitative analysis. Such traders might assess large-cap versus small-cap by comparing the return performances of $RUI and $RUT over a fixed period of time. Historically, the overall market has tended to perform better when the 252-trading day percentage rate of change (ROC) for large-cap stocks (represented by $RUI) exceeds the 252-trading day percentage ROC for small-cap stocks (represented by $RUT). The same holds true when comparing the 63-trading day percentage ROC for these two indexes.

The following examples show how a hypothetical investment in large-cap stocks (using ticker RUI as a proxy) would have performed under various circumstances, based on the relative performance of large-cap stocks versus small-cap stocks. The results are hypothetical, are intended for illustrative purposes only, and assume a starting date of December 31st, 1989.

From December 1989 through September 2014:

When the 252 ROC for $RUI was above the 252 ROC for $RUT, the large-cap Russell 1000 index ($RUI) gained over 550%. When the 252 ROC for $RUI was below the 252 ROC for $RUT, the large-cap Russell 1000 index lost almost 10% in value.

Figure 2 - % gain/loss for RUI when large-caps have outperformed (blue line) or underperformed (red line) small-caps over previous 252 trading days (Dec 1989-Sep 2014)

When the 63 ROC for $RUI was above the 63 ROC for $RUT, the large-cap Russell 1000 index gained over 440%. When the 63 ROC for $RUI was below the 63 ROC for $RUT, the large-cap Russell 1000 index gained only about 9%.

Figure 3 - % gain or loss for $RUI when large-caps have outperformed (blue line) or underperformed (red line) small-caps over previous 63 trading days (Dec 1989-Sep 2014

When either the 63 ROC for RUI was above the 63 ROC for $RUT or the 252 ROC for $RUI was above the 252 ROC for $RUT, the large-cap Russell 1000 index gained over 730%. When neither measure was positive, $RUI lost over 28% in value.

Figure 4 - % gain for $RUI when large-caps have outperformed small-caps over previous 63 trading days OR previous 252 trading days (blue line) versus all other trading days (red lines); Dec 1989-Sep 2014

Finally, when both the 63 ROC for $RUI was above the 63 ROC for $RUT and the 252 ROC for $RUI was above the 252 ROC for $RUT, the large-cap Russell 1000 index gained over 440%, and did so with a relatively low amount of volatility.

Figure 5 - % gain for $RUI when large-caps outperformed small-caps over the previous 63 trading days, as well as over the previous 252 trading days (Dec 1989-Sep 2014)

Summary

The stock market is a dynamic entity, comprised of many moving parts. One way traders may gain an edge in the marketplace is to compare the performance of one market segment to another and interpret the relative performance. When small-caps fail to confirm new highs achieved by large-caps, it may provide an early warning sign of a potential impending downturn in the overall stock market. Likewise, when large-caps are outperforming small-caps, it may provide incentive for traders to ride the large-cap wave.

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