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Divergence Between Small Caps and Large Caps Bares Watching

David Becker
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Divergence Between Small Caps and Large Caps Bares Watching

A divergence between different sectors of the market should be a concern to investors as small cap stocks which led the market higher until early March have failed to keep pace with large cap stock such as the S&P 500 index. Additionally, high yield bonds have also been under pressure which should raise a red flag for market participants.

Although the U.S. stock market has shown impressive resilience over the past few months, there are some troubling signs beneath the surface. One is the negative divergence between small caps and large caps. Since March 5, the S&P 500 Large Cap Index has gained more than 5%, while the Russell 2000 Small Cap Index has lost an equal amount. That negative 10% divergence is the biggest since 2011. Generally speaking, market rallies since 2009 have been led by small caps. That was the case between 2009 and 2011, and again during 2012 and 2013. The ratio between the Russell and the S&P 500 index continues to tumble.

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Another caution sign is coming from the bond market. Treasury bond prices hit a new 52-week high in a flight to safety, possibly from growing overseas tensions, High yield government bonds, however, have had a bad July. The da iBoxx High Yield Corporate Bond iShares (HYG) has been falling during the first half of the month on rising volume. Last week’s bounce was turned back at the 50-day average, which is now acting as a resistance barrier. Junk bonds are the riskiest part of the fixed income space and are the most closely tied to the stock market. That July divergence between high yield bonds and the S&P 500 is another troubling divergence. That’s because the two markets are highly correlated. The 50-week Correlation Coefficent shows a positive correlation of .96 between the two. During 2011, both experienced large downside corrections. They’ve risen together since thenuntil this month. That bears watching.

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