Should We Worry About Small Cap Stock Divergences?

Small Cap Stocks

The Russell 2000 has a lot of stocks in it, but the sum total of them doesn’t add up to much. If we want to track small caps, it is invaluable, but with big caps, it’s pretty meaningless.

Traders and investors will sometimes use intermarket analysis to attempt to gain some additional insight on where their preferred market may be heading. For example, after last week’s bear run, some have looked to the Russell 2000 index, which suffered a bigger decline than the bigger market averages, and point to the potential for this to be predictive of bearishness with indexes such as the Dow, the S&P 500, and the Nasdaq.

The Russell 2000 is derived from the larger Russell 3000 index, representing the bottom two thirds by market capitalization of the 3000 stocks tracked by the bigger index, which comprises 98% of all U.S. stocks.

The market capitalization of a stock is the product of the price per share that it is trading at and the number of shares outstanding. If the stock price is $50 for instance, and there are 50 million of these shares outstanding, the market capitalization of this stock would be $2.5 billion.

The bottom two thirds of stocks in the Russell 2000 index are companies with a considerably smaller market capitalization than the stocks that are in major stock indexes. They are called small cap stocks and the index is known as a small cap index. To give you an idea of the differences in size, the upper 1000 stocks in the Russell 3000 contain 92% of the market capitalization of all U.S. stocks, with the bottom 2000, the ones in the Russell 2000 index, only comprising 8%.

The total market cap of the Russell 2000 is about $2 trillion. This might seem like a big number, but Apple and Amazon’s market cap add up to a number this big all by itself, both about 1000 times bigger than the typical stock in this small cap index. The entire index together doesn’t really amount to all that much, especially given that the big cap indexes are so much larger.

We therefore need to be careful when we look to the movement of such a big collection of relatively tiny and insignificant companies, although it there was somehow a correlation with this small index and their phenomenally bigger brothers, we might have something potentially informative, even though such a thing would be quite counterintuitive.

Small Caps Indexes Really Only Portray Small Cap Stocks

If you are investing in a small cap mutual fund, and there are plenty of mutual funds that either specialize in small caps or include them in their fund holdings, then an index like this can be quite valuable. If you’re just investing in small caps, which really isn’t a great idea actually, then the Russell 2000 is what you are probably investing in, so its performance and yours will be married.

More often though, investors may be looking to spice up their portfolios with small caps, because these stocks do tend to be a little more volatile than large caps, and in this case, you would want to be looking at the Russell 2000 to get an idea of how your small caps are performing relative to the bigger indexes.

If we are expecting that this small cap index somehow leading the big indexes in direction though, that’s much more ambitious. This view has been described as the tail wagging the dog, or in this case the tip of the tail wagging it, and if there were good reasons why this should happen, this still might hold some water, but it doesn’t.

If we are wishing to predict the direction of a big index, large cap stocks in other words, we really need to be looking at large cap stocks, the ones in the index we are monitoring or at least some other index of large cap stocks. Looking at the index we want to predict directly is actually the most sensible approach, as we get a direct correlation with what we want to measure. The more what we are comparing it with differs, the weaker the correlation will be, which only makes sense.

Some think that because small caps are more domestically oriented, moving more with the direction of the U.S. economy rather than the global one, this might provide a basis or the predictive value they seek. However, things are all pretty connected, and weakness abroad, bringing down the larger caps, will also filter down to the small caps as well generally.

There is also nothing magical about how companies who do most or all of their business in the United States are doing, either fundamentally or with their stock prices, when the object of our concern is more global, if it’s where large caps are heading.

Money Moves Markets, but Small Money Doesn’t Move Big Markets

In order to get a better understanding of how markets move, we really need to understand that the price of a stock or an index is based solely upon the dynamic forces of supply and demand. Another way of understanding this is that if more money goes into a stock than comes out of it, the price goes up, and when more money comes out than it is put in, the price goes down.

Large caps are where the large money flows, and where the large money is flowing is going to mean a lot more to large cap stocks than where the small money is flowing, in and out of small caps. There may be some particular circumstances that may uniquely drive small cap prices, but not things that large cap traders and investors pay much attention to or care about very much.

If there is a big enough difference, if small caps are doing well for instance, this may cause people to invest more in small caps, and this can result in at least some outflows from big to small cap. This may predict something, a small amount of inflow or outflow with large caps, but nothing of any real significance, due to the sheer smallness involved.

The bond market, which is twice as big as the stock market, is a different story, and inflows and outflows from bonds can have big effects upon stock markets. This still doesn’t mean that this has predictive value though, as we need to demonstrate that changes in bond prices lead stock prices.

The effects of these changes occur at once though, when for instance money moves out of stocks and gets put in bonds, with the extra selling involved exerting downward pressure on stock prices. If you expect bonds to be likely to be more desirable later, these things can be used to predict prices, but this is not the same thing as looking at bond trends and trying to predict stocks based upon what has already happened in the bond market.

When we saw the Russell 2000 take a bigger hit than the big indexes last week, this did cause some people to think that this might mean that we are more likely to see more bearish conditions with the large indexes as well, due to the Russell 2000 divergence being predictive in some way.

Dave Lafferty of Nataxis Investment Management for example, is placing his money on all this being wrong and the Russell 2000 having at least some predictive value. He remarks that “small caps are very sensitive to where the market may be going,” and that the issues that have held back the economy lately tends to be more expressed at the more grass-roots small cap level.

This may be true, but we cannot therefore infer that if smaller companies are suffering more, larger ones soon will suffer more. Lafferty does point out that small cap indexes have a higher beta, meaning that they move more in both directions than large cap indexes, but that itself could be considered a sufficient explanation for this divergence.

The Russell 2000 is up about 22% since Jan 1, with the S&P only up 18%, but this is normal and expected. In the good times, small caps will move up more, as well as move down more during bad times.

During the pullback of last week, a bad time, if small caps lost more than big caps did, this event should not even be considered abnormal at all.

To really settle this, we can just look at the research on this by Ned Davis, who has showed that, if anything, large caps lead small caps. The dog does indeed wag the tail, although if we just keep our eyes on the tail and not the whole dog, we can get a little confused at times.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.