Wall Street's troops leading the generals

A particularly encouraging sign of stock market health has recently emerged out of the public’s eye: The marked strength of smaller, lesser-known stocks, which over the last few months have far outperformed the broad market indexes.

So far this year, for example, according to Standard & Poor's, the average small-cap stock has gained 4.6% and the typical mid-cap stock has gained 5.7% — vs. just 1.4% for the average large-cap company. The reason these smaller stocks’ relative strength has largely been overlooked is that those large caps play an outsized role in how the popular stock market averages are calculated. The big-cap-dominated S&P 500 index’s year-to-date return, for example, is just 1.4%.

This market-beating strength of smaller stocks is good news because they often lead the broad market—on both the up and the down sides. Wall Street discovered this tendency several decades ago, when a popular saying was that “if the troops will lead, the generals will follow.” The reference to the generals was to the large-cap stocks that then dominated the stock market and which also had “General” in their names — such as General Motors and General Electric.

Though those “generals” no longer dominate the stock market, the overall pattern persists. Stephen Leeb, editor of an investment advisory service called The Complete Investor, goes so far as to claim that “In no case for more than 40 years has a major market setback occurred when” secondary stocks were outperforming the broad market averages.

A good illustration of how small-cap stocks lead the broader market came last year, when the extraordinary gains of a handful of large stocks masked significant weakness among smaller stocks. Four large stocks did so well, in fact, that some referred to them as portfolio saviors: Facebook, Amazon, Netflix and Google — sometimes also referred to by the acronym FANG. Their average 2015 gains were 83%, in contrast to a 3.4% loss for the S&P 600 Small-Cap Index.

Sure enough, stocks hit a major air pocket earlier this year. The broad market averages suffered their worst start to a calendar year in U.S. stock market history.

One big reason why smaller stocks are a leading market indicator is that they are particularly sensitive to any imminent changes in the economy’s health. After all, their very survival is called into question during economic downturns. So at even a hint of trouble on the horizon, many investors will dump their smaller stocks and flock to the relative safety of the largest companies’ stocks. Just the reverse happens when that trouble appears to have passed.

So the smaller stocks’ recent strength is definitely welcome news, especially given the stock market’s weakness over the last week. Leeb believes that the worst case would be a 7% correction, and that the more likely outcome is “a new high in the not-to-distant future.”

To keep track of small-cap relative strength yourself, focus on the trailing three-month returns of a small-cap and a large-cap index. Leeb, for one, recommends that we give the stock market the benefit of the doubt so long as the recent return of the former is greater than the latter. Two easily-tracked indices in this regard are the S&P 600 SmallCap Index and the S&P 500 Index — with trailing three-month returns of 5.3% and 2.8%, respectively.

By focusing on trailing three-month returns, you will have plenty of advance warning when conditions begin to change. At least for now, however, the market’s prospects appear promising.

Mark Hulbert, founder of the Hulbert Financial Digest, has been tracking investment advisers' performances for four decades. For more information, email him at mark@hulbertratings.com or go to www.hulbertratings.com .