Stock Market Update: What Small Cap Weakness Signals

What does this mean for traders?

The behaviour of the largest stocks can vary dramatically verses the smallest stocks on the market. This has a couple of implications. 

Trading only small cap stocks can leave you struggling when in periods (like the last few years) when large cap stocks are out performing. We need trading systems for large stocks and systems for small stocks. If you don’t have these then you are probably leaving a lot of profit on the table.

It also shows that market indices can be very misleading as an indicator of the overall market health. Large stocks might be doing ok, but small stocks might be getting hammered. As much as there is correlation between stocks, there are significant areas of over performance and under performance. Our portfolios of systems need to be nimble and diverse enough to capture these.

I believe systematic portfolios should have strategies for large caps and strategies for small caps. I have a trend following strategy for small cap stocks that I have made a lot of money from over the years. However, in the last couple of years the performance of this strategy has been much weaker than my top 100 relative momentum (rotational) trading system.

Both of these strategies deserve a place in the portfolio… but either one in isolation is suboptimal in the long run. 

I have been playing with the idea of long term bottom picking using market breadth indices like the Percent of stocks below the 200 MA. I don’t have a workable system just yet, so if you have any ideas on this I would love to hear from your (rely to this email and let me know your thoughts and I will test them). 

What I have observed though is when the % of Russell 2000 stocks above their 200MA drops to below 10%, there is a solid chance of a substantial upmove in the S&P500 over the next 100 trading days (See red box below). This does not happen often and only occurs in the most extreme bear markets. This could be a good bottom fishing indicator for once in a decade type crashes but I have more work to do on this.

Currently, as at 2 May 2025, 25% of Russell 2000 stocks are above the 200MA, and the chart below shows no increased probability of a big S&P rally using this indicator. If anything there may be an elevated probability of a decline, but I think acting on that in advance would be a mistake.