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Michael Gayed: Small-Cap Stocks Broken for Right Reasons?

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Small-cap stocks are weakening further, but that doesn't have to be a bad thing if new trends emerge.

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The world breaks everyone, and afterward, some are strong at the broken places.
-- Ernest Hemingway

There have been some notable breakdowns in US small-cap stocks over the past few days. High-beta domestic stocks have had a stellar 2013, completely ignoring the deflation pulse that has been beating underneath the market's surface throughout the year. Now, a reversal appears to be underway as market participants take gains and sell off those areas that rose the most. The question is whether this is a bad thing for overall equities, or if stocks more broadly can continue to rally with large-cap stocks taking the lead.

First, let's address the concern with high-beta names breaking down. The argument here, which is valid, is that because small-cap stocks are less liquid than large-cap ones, and more volatile, that their relative performance can be indicative of underlying risk sentiment. If traders and investors are very bullish on the US economy and stock market, small-caps presumably attract the most attention because of how sensitive they are to cyclicality. The other side of this? Weakness might indicate money is fearing the future, and favoring less sensitive stocks.

So where are we now? Take a look below at the price ratio of the Russell 2000 ETF (NYSEARCA:IWM) relative to the S&P 500 (NYSEARCA:SPY). As a reminder, a rising price ratio means the numerator (IWM) is outperforming (up more/down less) the denominator (SPY). A falling ratio means the opposite, as large-caps outperform.



Note that the ratio does appear to be broken now and that a downtrend could persist; however, this may not be a bad thing. If large-cap stocks are being favored at the same time international, emerging markets are themselves turning around (as they appear to be), then this isn't a beta rotation, but rather one from domestic to global/multinational. The implication? If you want to be on a comeback in emerging markets, then from a relative standpoint you don't do that by being in US small-caps if you are focused on US stocks alone.

Small-cap tapering continues – and it's a good thing for those looking to emerge.

Twitter: @pensionpartners
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No positions in stocks mentioned.

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