There's a group of stocks not participating in the comeback and it could be a troubling sign

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A group of stocks that led the past two market rebounds is lagging this time around. And that may be a bearish signal.

Small caps — stocks with a market capitalization of less than $2 billion — originally kept pace with S&P 500 in a rally back from December lows. Markets had been hammered in the fourth quarter, but both indexes have regained more than 16 percent since late December.

But in the past two months, the Russell 2000 has been much weaker. The index of small-cap stocks is down by roughly 1 percent since late February. The S&P 500 is up more than 4 percent in the same time period.

Ned Davis Research warned of the trend out in a note to clients this week. The firm has small-caps “on watch” for a downgrade from neutral to bearish. Ed Clissold, chief U.S. strategist at Ned David Research, is still looking for confirmation that small-caps are warning of a broad market peak.

“The small-cap weakness has become a favorite point of emphasis of the bears, and not without reason,” Clissold said. “The small-cap warning is backed by rationale.”

For chart analysts, weak small cap shares mean the market has poor so-called breadth.

For other investors, it has macroeconomic implications. These smaller companies are generally more vulnerable to economic cycles. They tend to hold more debt than their large-cap peers, making them especially sensitive to things like rising interest rates and wage inflation.

“From a macroeconomic view, small-caps tend to be more economically sensitive, so under-performance can be a recession warning,” Clissold said.

One reason small caps usually lead rallies is that they tend to be less liquid. So when the stock market rises, they may get bid up more quickly, according to Dan Miller, director of equities at GW&K Investment Management.

Large-cap tech stocks are back in favor thanks in part to a change of direction in interest rate hikes. Higher rates bring up the cost of borrowing for large companies, and boost the appeal of bonds or defensive stocks instead of high-growth names. But the Fed recently shifted its stance, signaling no more hikes this year.

As rates come down, investors tend to pay up for high-growth tech names and are willing to look further down the road without discounting those stocks, according to GW&K’s Miller. The technology sector and the so-called FANG stocks have been among the biggest winners in the 2019 rebound.

“When interest rates started coming back down, you saw a really strong rally in these high-growth tech names,” Miller said. “It doesn’t mean there’s anything wrong with small caps.”

For the past two market corrections — a 10 percent drop or more — small caps led the drop, and then the recovery. But looking back further their track record of forecasting trouble for the broader market is “good, but not great,” according to Ned Davis Research.

“The data suggest that the small-cap warning warrants further analysis, but it is should not be taken as an outright sell signal for the broad market just because it has worked the last two times,” Clissold said.

Source: Ned Davis Research

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