Small Cap Divergence
Although there is considerable discussion about the divergence between the Nasdaq and the S&P500 or the Transports and the broader market, I am most intrigued by the action in the small caps. It's no secret that small cap shares have benefited from the liquidity of low rates. But the recent divergence between the Russell 2000 and the Small Cap 600 bears our attention. Year to date the Small Cap 600 is +1.42% while the Russell 2000 is -2.09%.
On the surface that difference doesn't seem to be material. But these two indices have moved in tandem since the October 2002 low. In fact, the SML outperformed the Russell by more than 3.5% over the last 40 days. Since the 2002 low, this marks the first time we've seen even a +3% difference in the SML - Russell spread over any 40 day period. Given the components of these indices (2000 issues versus 600), this divergence is a clear indication that leadership among the best performers (smaller cap shares) is narrowing.
Admittedly, the timing of an interim top is difficult to predict. If there's one thing we've learned from the past, it's that narrowing of leadership on its own is not grounds for an immediate top. But as I listen to the media calls for a breakout, I'm left wondering: Is this a breakout OR are we broken out?
Let's look at some facts. Coming into March, the Small Cap 600 was +80% in 25 months. The index closed positive in 20 of the last 25 months with 15 of those recording new 52 week highs. And barring a collapse this month to the 330 level, the SML will have gone 26 months without closing below the prior month's low. Read that sentence again. The Dow Jones Industrial Average accomplished such a feat just once in its entire history (1955).
So are we breaking out OR are we broken out? I guess the answer is entirely dependant on the category of shares you are long. But we cannot ignore the fact that smaller cap shares have given market breadth a solid foundation from which to rally. If indeed the leadership among those shares is narrowing (as well it should given a rising rate environment), then the Russell 2000 / Small Cap 600 divergence is equally important. Remeber that over the past year, new highs in the SML preceded new highs in the SPX. A potential sign of exhaustion in the small caps deserves our attention.
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