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Stocks of smaller companies are signaling a warning for all US markets

Canaries in the Coal Mine

By David Nelson, CFA

“The canary in the coal mine is always the first to go.” For more than a century miners carried them in small cages deep into the mine as an early warning detection system for poisonous gas or carbon dioxide. The first sign of distress in the cage sent the men back to the surface in a hurry.

Portfolio managers and traders are always looking for the Holy Grail — an indicator that can show if the path forward is safe. We spend fortunes on data terminals and hours developing quantitative systems that can help us avoid the next wiggle in the market or pull the ripcord before getting mauled by the bears. The answers we seek may be staring us right in the face.

Small cap stocks surged after the election, but have lagged recently. (Source: Bloomberg)
Small cap stocks surged after the election, but have lagged recently. (Source: Bloomberg)

The election was an adrenaline rush for small cap investors with the Russell 2000 Index (^RUT, IWM) jumping nearly nearly 17% in just 4 weeks. Even today, it’s up over 28% from a year ago. But year-to-date, it’s lagged its big brother large caps. With a nearly 400 basis point (4%) difference since the start of the year, it begs the question: What’s wrong with this picture?

Investors piled into these names after the election partly because they are US-centric companies. Infrastructure spending and an overall focus on the US should be good news here. Recently, investors aren’t buying it. These are the companies that should be benefitting from a Trump presidency. I’ve expressed my concerns in both the broadcast and print media that there is a huge disconnect between investor perception and the timeline of the administration’s proposals. Nowhere is this more evident than in the world of small cap stocks.

Large cap stocks are outperforming small cap stocks this year. (Source: Bloomberg)
Large cap stocks are outperforming small cap stocks this year. (Source: Bloomberg)

According to Goldman Sachs’ analysis of short interest as a percentage of stock float, it has spiked to a 1 year high in the energy and health care sectors for small caps. Add the fact that this could be the eighth consecutive quarter of outflows for the asset class, and any small cap manager would have to be concerned. It’s certainly a divergence we should watch. It may be masking some underlying weakness that isn’t showing up (yet) in the S&P 500 (^GSPC, SPY).

Transports are also struggling in the last few weeks, largely on the heels of bad news coming from airline stocks. Add a monster storm in the US canceling thousands of flights, and you get the message.

Getting Crowded

Investors are increasingly crowding into the biggest of the big. Of the 10 largest companies in the S&P 500, only Exxon Mobil (XOM) is down year-to-date, while the biggest stock, Apple (AAPL), is up a whopping 21%. It’s clear investors are using the biggest of the big to maintain market exposure while also keeping a margin of safety.

US stocks by market capitalization (Source: Belpointe)
US stocks by market capitalization (Source: Belpointe)

All these divergences need to be monitored. A one year chart of the Russell 2000 ETF (IWM) still looks healthy, but its underperformance this year is certainly a concern. No, the canary isn’t dead yet, but you can bet I’m not taking my eyes off the cage.

* At the time of this article funds managed by David Nelson owned shares of Microsoft (MSFT) & Wells Fargo (WFC).


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Investment advice is offered through Belpointe Asset Management, LLC. Past performance is no guarantee of future returns. Insurance products are offered through Belpointe Insurance, LLC and Belpointe Specialty Insurance, LLC. It is important to read our email disclosures available at this link: http://belpointe.com/disclosures.