Last September (9/21/2020), I wrote an article titled “Are Small Caps Rising from the Ashes.” Since that date, the Russell 2000 Small-Cap index, using IWM as a proxy, has all but doubled the return of the S&P 500 – with IWM returning 55.54% compared to 28.07% for the SPX.

Here’s a link to that article.

But, this is not 2020 and this is a very different environment for stocks – and small caps are not immune to the winds of change. So, I’m advising investors to keep an eye on small caps.

Small-cap stocks, or stocks with a market cap between $300 million-$2 billion, make up an estimated 40% of all stocks trading on the NYSE – So what they do can have major implications on the direction of the overall market. 

Here are two possibilities:

The Bear Case for Small Caps:

That this is a head and shoulders top, with waning momentum as the RSI (lower pane) continues to fall, taking the Russell 2000 down below 216, maybe all the way back to its 2020 break-out at 170?

But my message isn’t just about small caps. If small caps do break down, what does that say about stocks in general? What are the inter-market implications?

What could investors expect to see if small caps break down? How may you want to profit in this environment? Remember, successful investing means adapting to what markets throw at you.

If small caps do break below 216, it’s likely happening in an environment where stocks, in general, are under pressure (small, large, and everything in between). 

In that environment, I’d expect to see bonds catch a bid (bond yields fall) and more defensive sectors of the market like Consumer Staples and Utilities will likely outperform on a relative basis.

Here’s what 10-year yields look like now.

Yields look to have peaked in March and April, sitting at 1.58% today. If they continue to slip it’s because bonds are catching a bid and investor dollars are moving out of equities and into bonds. So advantage Bonds.

More often than not, the first stocks that get sold are the Small-Caps. So, keep an eye on Small Caps for any sign of further deterioration.

From a sector perspective, although Consumer Staples have been showing some outperformance relative to their growth counterparts (Consumer Discretionaries), both Staples and Utilities are ranked at the bottom of our relative strength matrix of 11 broad sectors. If this relative strength changes, and Staples or Utilities march higher, investors will be forced to adapt or be left licking their wounds.

The Bull Case for Small Caps:

Turns out this is not a Head and Shoulders top – just a messy sideways consolidation before small caps make their next move higher. Momentum doesn’t ever move to oversold levels and stocks move higher.

And because small caps are considered more aggressive than their large-cap cousins, I’d expect to see the more “risk-on sectors” maintain their position as relative strength leaders (i.e. Consumer Discretionaries).

From an Asset Class perspective, I’d anticipate Stocks over Bonds to continue to play out as the dominant inter-market theme to watch. In that scenario, Bond yields rise, as money rotates out of Fixed Income in favor of Equities.

So, as you can see, we’re not just thinking about if Small-Cap stocks are the place to be – Yes, there can be a trade from either the long-side or the short, based on what happens next. However, there are broader market implications to consider that savvy investors can take advantage of.

I’ll continue to watch small caps for any clear signs in the weeks to come.

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Until next week…