Small Stocks Lag

5/19/2014


With the Dow Industrials, Dow Transports, and S&P 500 Index closing at all-time highs on May 13, the primary trend is squarely in the bullish camp. Improved relative strength from small-company stocks would be encouraging, but their recent underperformance is not reason enough to abandon U.S. stocks. Our buy lists have 94% to 96% in stocks.

Small-stock divergence

The Russell 2000 and S&P SmallCap 600 indexes have slumped more than 6% from all-time highs in early March. Historically, weakness in these small-stock averages amid new highs in the blue-chip averages has been a yellow flag. But current conditions don't support an exit from the U.S. stock market, for several reasons:

• When small-stock averages are not confirming new highs in the Dow Industrials and S&P 500, it can signal that the major averages are relying on a small number of big blue chips. But that is not the case today. The S&P 500 advance-decline line, a running daily total of advancing minus declining stocks, reached an all-time high on May 12. So did the S&P MidCap 400 advance-decline line. For the broad S&P 1500, the advance-decline line is only slightly below the April 22 all-time high.

• Underperformance from small-company stocks can signal impending weakness in the U.S. economy, as small companies tend to be more domestically oriented and economically sensitive. But cyclicals are not driving the recent small-stock pullback; both the Dow Transports and Morgan Stanley Cyclical Index reached all-time highs on May 13.

• Considering the huge advance in the small-stock averages in the 16 months ended March, which lifted small-stock valuations to unusually rich levels versus big stocks, the recent pullback may not be signaling anything more than investors' worries regarding overvaluation. Indeed, the damage has been concentrated in the most richly valued small stocks. The average stock in the S&P SmallCap 600 is down about 5% so far in 2014.

• Every market cycle is different, and the unprecedented impact of exchange-traded index funds is a notable feature of the current environment. The largest exchange-traded fund for small stocks, the iShares Russell 2000 ETF ($110; IWM), lost 8.6% of its assets in the week ended May 8. Never before has it been so easy to put so much money in motion, and investors may need to get accustomed to rapid sector rotations.

Conclusion

The weakness of small stocks merits watching, but the bullish primary trend remains intact. Subscribers should emphasize such attractively valued growers as Alaska Air ($98; ALK).


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