Small-Cap Stocks Lag Behind, Indicating Potential Market Growth

Small-cap stocks have been trailing behind their large-cap counterparts for the past 12 months, which may initially be frustrating for small-cap investors. However, based on historical data, this situation could actually signal positive prospects for the overall stock market's future performance. Charlie Bilello, the chief market strategist at Creative Planning, a wealth-management firm overseeing over $200 billion in assets, has highlighted this interesting trend.

According to FactSet data, while the S&P 500 has risen by a substantial 21% in the last year, the small-cap equity gauge, Russell 2000, has only seen a modest gain of 4.9% during the same period.

Bilello points out that historically, periods of small-cap underperformance, also known as "weak breadth," have typically been followed by above-average returns for stocks. Conversely, periods of small-cap outperformance, or "strong breadth," have generally resulted in below-average returns. This pattern suggests that the current small-cap lag may be a potentially bullish indicator for the market's future performance.

Another crucial factor contributing to this analysis is the significant disparity between the S&P 500 and the Russell 2000 at present. With the S&P 500 trading near its record high while the Russell 2000 remains almost 20% below its peak close. According to Bilello, this setup bodes well for the performance of stocks in the next 12 months.

Bilello further notes that during the three most significant drawdowns of the Russell 2000 when the S&P 500 reached a record high, both indexes experienced rallies in the subsequent year. Additionally, although the sample size is small, the Russell 2000 not only outperformed following these drawdowns but also joined the S&P 500 at its record highs.

For example, after the Russell 2000 saw a 19.2% decline from its local high in April 1999, the S&P 500 rose by 14.3% over the following year, and the Russell 2000 gained an impressive 36.5% during the same period. Similarly, in February 1991, following a 13.5% drawdown for the Russell 2000, the index increased by 35.5% in the subsequent year, while the S&P 500 saw a gain of 12.1%. Likewise, in January 1985, after a 13.3% decline for the Russell 2000, the S&P 500 rose by 17.4% over the next year, and the Russell 2000 gained 18.2%.

Overall, despite small-cap stocks currently trailing behind, their performance could indicate potential growth and positive market conditions moving forward.