The indicator discussed in this article compares the strength of iShares Russell 1000 over iShares Russell 2000 . Large-cap stocks tend to lead smaller-cap stocks when investors are anxious about economic conditions. The situation doesn't automatically mean equity indexes will decline, just that investor caution has pushed money into defensive sectors.
When small-cap stocks lead, it implies that investors are confident in the overall economy. They are more willing to take risks in riskier equity sectors, believing that strong financial markets will help companies both large and small.
Throughout 2013, equity indexes rallied at an exponential pace. Small-cap stocks showed relative strength the entire year, steadily climbing higher every quarter. Equity investors had little fear, knowing the Federal Reserve had a safety net below the market, deterring sellers from getting too bearish.
Things have changed, however, in 2014. The Fed has cut its monthly bond purchases by $20 billion over two consecutive meetings. Investors are no longer hopeful that central bank help will be there if things go wrong in the economy.
U.S. economic numbers have been mixed, as higher growth has come alongside a slow growing labor market. Investors are looking for a faster recovery if the Fed intends to remove stimulus completely by the end of the year.
Large-cap stocks, as well as safe-haven assets, have been bid higher, as investors slowly realize that they are on their own now. Over this past month, both the iShares Japanese Yen Trust and iPath S&P 500 VIX ST Futures ETN have shown strength. Emerging-market issues have been partially responsible for the rise, but investor caution surrounding the future direction of equity markets has played a role as well.
This all sets the stage for large-cap leadership in coming months. The relative strength indicator shows large-cap stocks forming a double-bottom reversal pattern. The pair is trading at its lowest level in five years, indicating oversold levels.
This coincides with equity markets trading at record highs, and beginning to show signs of breaking lower. Watch the future action of large-cap leadership as a signal that investors are cautious and moving funds out of higher risk investments.
IWB data by YCharts
At the time of publication the author had no position in any of the funds mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.