A rare split in fortunes between America's smallest and largest companies could be spelling trouble for markets
- Small-cap stocks, which have market caps of less than $2 billion, have recently been underperforming large-cap stocks.
- The gap in September was the largest in four years and triggered a bearish signal, according to S&P Dow Jones Indices.
- "At the very least, we expect small caps to undergo a price correction led by systematic trend-follower selling until its volatility calms down," Nomura said in a note.
Small-cap stocks were the outperformers of the market this year until recently.
For three months, the group of companies with market caps of less than $2 billion has underperformed large-cap stocks. In September, the divergence has become so significant that it became a bearish signal, according to Jodie Gunzberg, the head of US equities at S&P Dow Jones Indices.
In September, Gunzberg said, the S&P 500 climbed to a new high with a 0.43% gain while the S&P SmallCap 600 fell behind with a 3.32% decline.
This created the biggest outperformance gap on a monthly basis in four years. And it's a rare occurrence: over the past quarter century, the small-cap index has outperformed the S&P 500 roughly 8% of the time, Gunzberg said.
"Not only is this the current scenario, but the bearish divergence has only been bigger seven times in history where two of those times preceded major stock market drops," she said and illustrated with the chart below:
Gunzberg added that "even if the large cap outperformance does not happen exactly on the market high, or if the bearish diversion signal is just the first of many, it seems there may be a bearish signal from the inability of small caps to keep up with the large cap momentum."
There's evidence in the Russell 2000 futures market that small caps are losing ground, according to Nomura. Its Tokyo-based cross-asset strategy team estimated that commodity trading advisors (CTAs) have systematically sold futures to cut long positions since the index hit 1,660, which was the average entry cost of the long positions they had built up since April.
"At the very least, we expect small caps to undergo a price correction led by systematic trend-follower selling until its volatility calms down," Nomura's Masanari Takada said in a note on Wednesday.
On the other hand, Gunzberg noted that there are still fundamentals in place that could lift small caps, including strong economic growth and a rising dollar.