By Paul J. Lim
November 9, 2017

Stocks have been delivering sizeable gains throughout the year with one big — or should we say small — exception.

So far in 2017, shares of small companies have returned around 10% on average. While decent by historical standards, that trails the 22% gains for large, blue chip companies in the Dow Jones industrial average.

That double-digit differential is actually quite important, as small-stock underperformance has typically foreshadowed downturns in the whole market. In fact, many strategists consider small stocks — which are the first to surge in a new bull market but are also the first to start lagging before a bear — Wall Street’s canary in the coalmine.

If you look at five of the past six bear markets, each occurred shortly after shares of small companies trailed large stocks by at least 10 percentage points.

The 2008 market crash during the global financial crisis, for instance, was preceded by an 11 percentage point gap between large stocks and small ones in 2007, according to data collected by Ibbotson Associates.

The tech wreck that began in March 2000 was foreshadowed by the 36 percentage point differential between large and small stocks in 1998.

But it’s not just the mega bears. The relatively mild 20% decline in the S&P 500 from July 1990 to October 1990 came after a year in which small stocks trailed large ones by nearly 22 percentage points.

The “Black Monday” market crash in October 1987 came after a year in which small stocks trailed large ones by nearly 12 points. And the 1973-74 bear was also preceded by a bad year for small stocks in 1972, when they trailed blue chip shares by nearly 15 points.

This year, “small-caps and value names have struggled to keep up despite a brief rally into the end of September,” notes Piper Jaffray market strategist Craig Johnson.

Why?

Part of it is an earnings story, as profit growth among companies in the Russell 2000 index of small stocks lags that of the S&P 500 index.

Part of it could also be a sign of a lack of confidence in Congress’s ability to pass tax cuts. In theory, small stocks should outperform large caps in the run-up to corporate tax cuts, because small stocks generate the vast majority of their sales and profits domestically — making them subject to U.S. tax rules. So any potential tax cut would benefit them disproportionately.

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By comparison, many blue chip companies are multinationals that generate nearly half of their sales overseas. “The underperformance of mid- and small-cap stocks since the start of (the fourth quarter) signals that tax reform may not be a shoe-in,” noted John Stoltzfus, chief investment strategist for Oppenheimer Asset Management.

But this could simply be a winnowing process. In the early going, bull markets lift most boats, with shares of small-, medium-, and large-sized companies all typically rising at the same time.

Over time, however, investors are less willing to bet on smaller, riskier companies and instead focus mostly on the biggest and most dominant companies in the market that are considered surer bets.

If that’s where investors’ heads are at, that could be a troubling sign for the market going forward.

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