Small cap stocks signal risk on

Dean Christians
2021-11-09

Key points:

  • The ratio between small and large stocks surged to the highest level relative to its recent range
  • The S&P 500 rallied 79% of the time over the next 2 months after other signals

Using small-cap stocks as a way to identify risk-on cycles 

A trading model that measures when small-cap stocks reverse from underperforming to outperforming relative to large-cap stocks issued a buy signal at the close of trading on Monday.

The small-cap range rank signal triggers when the 4-month range rank for the ratio between small and large stocks reverses from less than 1% to greater than 98.75%. Typically, when small-cap stocks surge relative to large-cap stocks, economic growth accelerates, and stocks perform well.

Small-cap stocks join other risk-on relationships with recent signals

A couple of other risk-on signals triggered within the past month as well, showing a quickly increasing risk appetite among investors.

  1. Copper versus gold risk-on signal
  2. High beta versus quality risk-on signal

In a recent note, Jason highlighted a breakout in the Russell 2000 index. They have continued to perform relatively well, pushing the Relative Ratio Rank to 100%. The previous risk-off to risk-on signal from October 2020 led to a substantial rally for the S&P 500.

Small cap stocks signal risk on

The S&P 500 rallied 79% of the time after other signals

This signal has triggered 42 other times over the past 43 years. After the others, future returns in the S&P 500 were solid across all time frames, with several solid risk/reward profiles. And, the signal has recorded 13 consecutive winning trades over the next 2 and 3 months since 2009.

Most of the unfavorable signals occurred during bear markets, which is not the case now.

Small cap stocks signal risk on

What the research tells us...

When small-cap stocks surge, it suggests the economy is undergoing a resurgence in growth that provides a tailwind for the stock market. Similar setups to what we're seeing now have preceded rising prices for S&P 500 over the medium-term.