Are Small Caps Signaling a Warning for the Stock Market?

As veteran investor and money manager Bob Farrell has noted, the market cannot continue to rally with just a few large-caps (generals) leading the way. Small and mid-caps (the troops) must also be on board to give the rally credibility. A rally that lifts all boats indicates far-reaching strength and increases the chances of further gains.

As seen in the chart below, small caps relative performance vs. large caps peaked in May, 2011.  Since then, performance has lagged, and has taken a pointed hit as recently as March, 2013.  Studies have also noted that small-cap firms tend to outperform large-caps over the years subsequent to an economic trough. In the year prior to the business cycle peak, however, small caps tend to lag. This would appear consistent with the slowing down of economic growth after the sharp run-up of GDP following the 2009 trough. The lagging small-caps may be a warning sign that a peak in the economic cycle is emerging.

Also noted in the chart above, there has been a lag of about 2 years between the peak in small-caps and the peak in the S&P500.  If this relationship holds, it would suggest a stock market peak in the relative near-term.

Taking into consideration the slowing economic momentum and the historic technical relative performance of small-caps vs. large-caps, a potential warning sign emerges for the stock market in general. 

- Baseline Analytics