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Despite the record rally, this could be a big problem for stocks

Big trouble from small caps

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Big trouble from small caps

Big trouble from small caps
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Small caps might be signaling some big worries ahead for large-cap indices, especially the Nasdaq Composite Index.

Since the market bottomed in March 2009, the small-cap benchmark Russell 2000 index has led much of the broader market. But, since the start of this year, it hasn’t been just a laggardit’s actually in negative territory.  Meanwhile, the S&P 500, the Dow Jones Industrial Averageand the Nasdaq composite index are all up for the year.

Could this mean the broader market indices could be in trouble? 

(Watch: Market trading on fear: Pro)

Gina Sanchez, founder of Chanticol Global, believes so. “It is indicative of a bigger problem,” she said. “When we have a recovery, the small caps do tend to lead that charge. It is seen as a sign of a healthy economy to have small caps substantially outperforming large caps in the early segment of a recovery [as] people are buying growth. That’s not happening this year.”

With downward revisions on forward guidance for many smaller capped companies, values are looking stretched, Sanchez said. What’s more, many in the Russell 2000 don’t even have positive earnings.

“It didn’t help that Janet Yellen… basically called them out, saying small caps and biotech were substantially stretched,” said Sanchez, a CNBC contributor. “If you look at the small caps, you have an enormous number of companies that have either negative or no earnings.”

As investors turn more critical of small caps, they are putting their money elsewhere but Sanchez believes that may not work out so well over the next few months.

“Even though some of that money has been going into the large caps, it’s indicative of a bigger problem,” she said. “It’s indicative of high expectations and not enough actual earnings to justify those expectations. That’s what’s likely going to happen in the second half of this year for large caps.”

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But Steven Pytlar, chief equity strategist at Prime Executions, is not too worried about the broader market indices such as the Nasdaq Composite, which had until a few weeks ago traded closely with the Russell 2000 for several months.

(Watch: Industrial giants reveal state of earnings play)

“Going back to January 2013,” he said, “the Russell 2000 really outperformed the entire Nasdaq, which is three and a half times bigger than the Russell.”

In 2013, the Russell 2000 also outperformed the Nasdaq 100 index which is composed of the Nasdaq’s larger cap names, notes Pytlar. “Now we’re really just seeing a move back to the mean,” he said. “They’re seeing outperformance in the higher-quality names in the broader NASDAQ. Meanwhile, the Russell, which is really the most speculative and the smallest of the small within the NASDAQ – they do have a little bit of overlap – is starting underperform.”

Pytlar believes the Russell 2000 current underperformance is only natural after a long period of outperforming larger-capped indices.

“It’s an indicator that the economy is maturing [and] that the market is maturing,” Pytlar said. “We’re looking at companies that do buybacks and dividends; higher interest rates mean smaller companies may not be able to get as much financing. We think it’s very natural.”

To see the full discussion on the Russell 2000 and the Nasdaq Composite Index, with Sanchez on the fundamentals and Pytlar on the technicals, watch the above video.

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