US stock market diverging -- what is the implication?

Some market analysts have noted that there has been a divergence in performance between the large-capitalisation stocks in the United States and the rest of the market. While such a divergence is widely regarded as bearish by traders, the longer-term implication may not be as negative.

Last week, the Dow Jones Industrial Average closed at a record 16,583.34. The Standard & Poor’s 500 Index fell 0.1 percent to 1,878.48. The Russell 2000 Index of small companies fell 1.9 percent to close below its average price for the past 200 days for the first time since 2012.

The divergence in performance between the large-cap stocks and smaller stocks has not just been for the past week. In a post on 9 May, Sam Ro at Business Insider cited an analysis by JC O'Hara of FBN Securities that noted that while the Standard & Poor's 500 Index is down just 1 percent from its all-time high of 1,897, many stocks in the index and in the market as a whole have performed much worse.

O'Hara found that the average S&P 1500 stock is down by more than 12 percent from the recent 52-week high while the average stocks in the Russell 2000 and Nasdaq Composite are down by more than 20 percent.

“Historically, this sort of divergence does not bode well for the longevity of a market’s upward inertia,” said O’Hara. “We went back and examined instances where the market made a new high and looked at where the median stock sat compare to its high. Our data suggests that the current breadth reading is very unhealthy. Not only are new highs diminishing but we are seeing many stocks making new lows. This breadth divergence is a major concern.”

Indeed, a week earlier, Brett Steenbarger at TraderFeed had already noted the divergence in performance between the large-capitalisation stocks and the rest of the market.

“The large cap indexes, such as the Dow and SPX, have been making or have been close to making all-time highs,” he wrote. “If we look at the broad universe of common stocks, however, we can see that more are making 3-month new lows than new highs.”

“A strong trend, like a strong tide, should lift all ships. A number of ships remain beached at the moment.”

However, in a post on 10 May, Steenbarger noted that the underperformance of small-cap stocks “has tended to occur during corrective market periods” but that such periods often “ended up heralding very good long-term buying opportunities for stocks”.

The caveat to the finding on long-term potential is that in a true bear market, a period of underperformance can be followed by greater underperformance before they lead to superior returns.

Nevertheless, Steenbarger concluded: “Given that the current underperformance is occurring in a low VIX environment, it is not clear to me that we are witnessing a repeat of 2011, 2008, late 2007, or 2002. The underperformance of small caps has not been a precise timing measure for stocks but on average has occurred during periods of risk aversion that have yielded positive forward returns for investors over the medium term.”