Coming up out of the June 4, 2012 bottom, it has been encouraging to see small stocks leading the way.  When small caps are outperforming large cap stocks, that tends to be a bullish condition for the overall market.

There are two main reasons for this.  The first part of this phenomenon has to do with the principle known as “beta”, which refers to how much a stock moves for a given move in “the market”.  Most of the time, the comparison to "the market" involves the behavior relative to the SP500.  Small cap stocks typically have betas above 1.0, so if the market is moving upward then small caps will move up more, and that shows up in indicators like the relative strength ratio shown in the chart above. 

The other part of the magic of small cap strength being good for the overall market has to do with liquidity.  Small cap stocks are often the least deserving issues for investment, owing to their speculative nature, and/or a smaller float.  So when small caps are doing well, it is a sign of plentiful liquidity.  If there is so much money wanting to get into the stock market that even the small caps can do well, then that means there is enough to lift all the boats, and so the market does well.

Relative Strength of Russell 2000 vs 1000

The relative strength ratio in the chart above is calculated simply by taking the value of the Russell 2000 Index and dividing it by the Russell 1000 Index.  If the line is moving upward, it means that small caps are outperforming on a relative basis.  That outperformance might be from going up faster, or going down slower. 

One of the fun things that this relative strength ratio does is that it will often show a breaking of a trend line ahead of the corresponding trend line break the price chart.  We also see that when this relative strength line is above its 5% Trend (AKA 39-day exponential moving average), that tends to be a good period for the Russell 2000 and indeed for the overall market.

But sometimes relative strength can be too much of a good thing.  This week's pop in small cap stocks has taken the relative strength ratio up well above its 5% Trend.  We can see that spread much better in this next chart, which measures how far the relative strength line is away from its 5% Trend.

Relative Strength Ratio deviation from 5% Trend

When this indicator gets outside of about plus or minus 2.5%, it shows that the short term price move has gotten extended, and that a mean-reversion move may be coming.  In other words, while small cap relative strength is good, the rubber band has gotten a little bit stretched, and that makes continued small cap outperformance less likely until after an equilibrium has been restored. 

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This article originally appeared at McClellan Market Report. Copyright 2014.