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Small caps serve up big warning

Talking Numbers

Small has a big warning for the market.

On Friday, the small cap benchmark index Russell 2000 saw its worst day since Feb. 3. The index was down 2 percent, double the percentage loss of the overall market benchmark S&P 500.

Russell 2000's underperforming the S&P 500 has been a general theme lately. So far this year, it’s down 0.7 percent while the S&P 500 is up 1 percent. In the last six months, the Russell 2000 is up 7 but the S&P 500 gained 10.5 percent during the period.

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That isn't to say the Russell 2000 is always the laggard. Over the past 12 months, it has actually outperformed the S&P 500 by 5 percentage points, returning 24.8 percent versus the S&P 500's 19.8 percent.

But the recent performance doesn’t come as too big a surprise to some.

"Small caps came into this year very, very overvalued–even more overvalued than the S&P 500," said CNBC contributor Gina Sanchez, founder of Chantico Global.

The downsides and the upsides in the macroeconomic picture will make it harder for small caps to succeed, she said.

"The downsides are: We've seen increasing payrolls but we haven't really seen wages and job quality hasn't gotten any better," she said. "The upside to the economy is we may actually see we have quite a bit of pent-up demand in the [capital expenditure] space. …  While that downside is very negative for small caps, that upside is very positive for large caps. No matter how you look at it, I end up preferring large caps right now to small caps."

Mark Newton, chief technical analyst at Greywolf, says the recent underperformance of the Russell 2000 relative to the S&P 500 is something investors should watch closely.

Last May, the price of the Russell 2000 was slightly below 59 percent that of the S&P 500. By September, it was around 64 percent. It remained in a range between 62 percent and 64 percent since then but closed Friday at 61.8 percent of the S&P 500.

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Newton notes that the market hasn't seen a full 10 percent correction in the past couple of years. But, with small caps stocks underperforming, that could be a reason to worry, particularly because the Russell 2000 is trading at under 62 percent of the S&P 500.

"Now you're starting to see a meaningful slowdown in small caps versus the broader market," Newton said. "The real key here technically is when we break to new monthly lows. That hasn't happened yet. But, on a move down under the lows that we've seen in this ratio of Russell to S&P over the last few months, that would be a very big concern."

The concern is that the broader market will start to deteriorate, according to Newton.
"We always want to watch small caps," he said. "They tend to lead the way."

Newton thinks there's a possibility for a correction in the spring and summer, since fewer stocks are hitting new highs.

"We're starting to see a lot of the go-go momentum stocks roll over," he said. "So, small caps breaking down versus the S&P would be a big negative."

To see the full discussion on small cap stocks, with Sanchez on the fundamentals and Newton on the technicals, watch the video above.

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