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Are Small Caps Sending a Warning About the Market?

Are Small Caps Sending a Warning About the Market?

When the Dow Jones Industrials (^DJI) hit an all-time high following the Fed's recent meeting, it was front page news across the country. Similarly, the S&P 500 (^GSPC) also burst higher to its own record close, seemingly immune from the reality that the central bank's unexpected decision was predicated on economic weakness.

But as the accolades and confetti were showering down upon these esteemed benchmarks of big business, a barometer of smaller companies measured by the Russell 2000 (^RUT) was enjoying a victory lap of its own, albeit without the fanfare and hype given to its larger peers. Rather than feeling slighted, most small cap investors prefer it this way, caring only for the short and long term performance advantage they are enjoying.

"We found that small cap stocks, as long as we're in bull market mode, tend to be in a leadership position," says Sam Stovall, chief equity strategist at S&P Capital IQ in the attached video, "and this year is no different."

In fact, the out-performance of the so-called little guys has been so pronounced for so long that some are thinking that, should their five-year rally come to an end, it could be a warning sign that new leadership is coming or perhaps that a small cap retreat might be a precursor of a broader sell-off that would take down the big boys along with them.

But Stovall's research shows that's just not the case.

"I found that small caps do not serve as a viable canary in the coal mine warning us of an impending bear market," he says noting one peculiar exception --''year five of a bull market."

For whatever reason, the fifth year of past up-cycles has seen large caps take the lead for a moment, before slipping back again in year six. This is not to suggest that small caps collapse, he says, it's just that large caps, for that brief period pull ahead.

"We're technically in year five now, and will celebrate our 5th birthday on March 9, 2014," he says, predicting that a "late cycle surge" by the small caps in year six would not be surprising.

To be sure, he says small caps are more exposed to rising interest rates since that tends to need to borrow more than their cash-rich larger peers and are also more leveraged to domestic economic growth. That said, Stovall urges investors to not only focus on the calendar, but to look at fundamentals too, especially since he says S&P Dow Jones Indexes is forecasting that both mid cap and small cap earnings growth will exceed that of large caps in 2014, or year six of the bull market.