Small-cap stocks trigger a risk-on buy signal

Key points:

• The ratio between small and large stocks surged to the highest level relative to its recent range
• A trading model that monitors this relationship triggered a new buy signal last week
• Large-cap stocks rallied 77% of the time over the next two months after other signals
• Small-cap stocks rallied 74% of the time over the next month after other signals

Economically-sensitive small-cap stocks as a broad market risk-on barometer 

Since the 6/16/22 low, the Russell 2000 is up 16%, while the S&P 500 has managed to gain 13%. The outperformance by small-cap stocks is a welcome development. Historically, small-cap stocks have performed better than large-cap stocks in the initial stages of a new cyclical uptrend.

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 last Friday. The model is a component of the TCTM Composite Confirmation Model.

The Small Cap/S&P 500 Relative Ratio 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 97%. 

The S&P 500 rallied 77% of the time over the next two months after other signals

This model triggered a signal 43 other times over the past 43 years. After the others, large-cap stocks performed well across all time frames, with several meaningful risk/reward profiles and z-scores. While the signal avoided a whipsaw alert in the 1980-82 bear market, it struggled during other significant drawdown periods, especially in 2000-02.

The Russell 2000 rallied 74% of the time over the next month after other signals

Small-cap stocks also enjoyed robust results, with solid risk/reward profiles and z-scores across all time frames. And, the bear market signals look significantly better compared to S&P 500 results.

Small-cap stocks tend to outperform large-cap stocks

Looking at the net difference between S&P 500 and Russell 2000 returns, the outlook table suggests a more favorable environment for small-cap stocks. 

What the research tells us...

When small-cap stocks reverse from underperforming to outperforming large-cap stocks, the resurgence in more economically-sensitive stocks provides a tailwind for the overall market. Similar setups to what we're seeing now have preceded rising prices for the S&P 500 and the Russell 2000, with solid risk/reward profiles and z-scores across all time frames. An allocation to small stocks looks more favorable in bull and bear market environments.