Small-cap stocks have crushed the performance of the S&P 500 by more than 2.5X over the last 3 months, returning a staggering 34.27%.

Can it last…?

Most of our ADAPT articles focus on sector rotation – sharing with our readers the relative strength relationships that we analyze between one sector or industry group vs. another.

However, the last three months have really been less of a sector rotation story and more about the market capitalization rotation that’s taken place between mega-cap & large-cap growth stocks and small/mid cap stocks.

This rotation from large to small cap is evident in the performance charts below.

Here is a one month chart of the Russell 2000 Small Cap index’s outperformance over mega-large and large-cap indexes of the Dow, S&P 500 Index and the tech heavy Nasdaq 100.

The Small-cap Russell 2000’s one month return of 11.04% (12/22/2020) has nearly tripled the return of the large-cap S&P 500 index, 3.77%.

And on a three month basis small caps have outperformed the S&P by more than 2.5X with an eye popping return of 34.27%.

Most of the financial news each day often centers around the performance of the Dow Jones Industrial Average or the S&P 500 index.

Whereas the rotation in relative strength between small-caps stocks and large-cap stocks has been lost in the daily news feeds.

Below is a simple price chart of IWM -representing small cap stocks (black line). I’ve added a Relative Index Comparison (RIC) in the lower panel (green line) – this allows us to illustrate the relative index comparison between small caps stocks (IWM) and the large-caps (SPX).

Here’s how the RIC, in the lower panel, works: a falling green line on the relative index comparison would indicate IWM is underperforming SPX, as it did in Feb-March. A rising green line is just as it sounds, IWM is rising against or outperforming SPX.

This relationship changed dramatically in September, as the big money players on Wall Street began shifting enormous sums of investment capital from large to small cap stocks.

This shift in capital for small cap stocks is what caused prices to surge 34.27% over the previous 3 months, while the S&P rose 12.59% and also caused the RIC to shift in favor of small caps (right rising red arrow).

The market capitalization rotation away from large-caps isn’t isolated to just small caps. We’re seeing a similar rotation into micro caps as well.

Mega-cap stocks are falling like the proverbial ‘hot knife through butter’ in the ratio chart above – as two important areas of resistance turned support for mega-caps on a relative basis have been quickly taken out.

This ratio only serves to provide further evidence that the rotation taking place on the capitalization level is real and investors should take note.

I’m guessing the question readers will ask next is – can small-cap stocks continue to outperform their large-cap peers?

Well, if small-caps are going to maintain control as the dominant market cap as we move into 2021, this would seem to be a logical place for that to happen.

Here is a relative strength comparison chart between IWM – representing small-caps and QQQ – representing large-cap stocks.

IWM recently bounced off its previous lows vs large-caps that go back all the way to 2000. So, if IWM holds above this key level, then it’s possible small-caps could make another run from here.

Although today’s narrative is all about market cap rotation – from large to small-cap stocks, it is not a directive to rush out and sell your large-cap holdings in favor of small.

The real point is to be aware of these shifts in market capitalization, to better position yourself to take advantage of what markets are offering up.

I’ll be watching this ratio in the coming weeks, looking to see if small-caps can continue to outperform or if large-cap stocks were just taking a pause and digesting their big gains of the last six months before the next possible leg higher.

Until next time…