Small-Cap Stocks Are In a Full Blown Correction of Greater Than -10%...

Performance of 12 Individual Asset Classes Over The Last 15-Years

1st Quarter 2011 Stats: S&P 500, Small Caps, Foreign Stocks, T-Notes

The S&P 500 gained +5.9% in the 1st quarter of 2011.  For all of calendar year 2010, the S&P 500 gained +15.1%.  The S&P 500 has gained an average of +9.7% per year (total return) over the last 50 calendar years (i.e., 1961-2010) (source: BTN Research).    

As of its end of the 1st quarter closing value (1326), the S&P 500 is still -18% below its all-time closing high of 1565 set on 10/09/07. (source: BTN Research).     

The international stock index EAFE gained +3.4% YTD (total return) through 03/31/11 and is up +10.4% on a trailing 1-year basis as of the end of the first quarter this year.  The EAFE stock index has bested the S&P 500 on a total return basis in 7 of the previous 10 calendar years.  The EAFE is an unmanaged index that is generally considered representative of the international stock market (source: BTN Research). 

The small-cap Russell 2000 is up +7.9% YTD (total return) through 03/31/11 and is up +25.8% on a trailing 1-year basis as of that date.  The Russell 2000 index is an unmanaged index of small-cap securities which generally involve greater risks (source: BTN Research).     

The yield on the 10-year Treasury note was 3.46% on 03/31/11.  The yield on the 10-year Treasury note was 8.05% on 03/31/91 or 20 years ago (source: Treasury Department). 

Small-Cap & Mid-Cap Stocks Post New Recovery Highs!

On Friday April 1st, small-cap and mid-cap stocks (not shown) posted new weekly bull market recovery highs.

When these two sectors lead the market higher, it's been a bullish omen, historically.

In addition, downside stock market risk has been below average and upside potential has been above average in similar historical climates.

Lagging Small-Cap Stocks A Bearish Omen...

Both the Dow Jones Industrial Average (DJIA) and small-cap Russell 2000 closed at a 52-week high two weeks ago, and then the DJIA closed at another high last week while the Russell 2000 lost more than -1%.

Going back to 1979, this has occurred only 3 other times...

1. April 1, 1998, after which the DJIA lost more than -15% during the next six months, while never gaining more than +2.5%.

2. January 7, 2000, after which the DJIA lost more than -14% during the next two months, while never gaining more than +1.8%.

3. January 19, 2007, after which the DJIA lost more than -4% during the next two months, while never gaining more than +1.8%.

Typically, when small-cap stocks fail to lead the market, stock market advances are hard to come by and downside risk is above average.

Small Caps Likely To Maintain Leadership During This Stage of the Cycle

You have to go all the way back to 1947 to find a bull market rally that made it through one year but did not last a second. And historically, the average stock market gain in the 2nd year has been +12.2%, a bullish omen for 2010.

So the prospects for stocks in 2010 are favorable because it's still early in the recovery phase. Moreover, either the small-cap growth or small-cap value sectors have shown the best 1-year performance in all but 1 of the past 10 stock and economic recoveries dating back to September 1953.

Of the 2 small capitalization categories, small growth led in 7 of these 10 recoveries and small value in 2. Only once, during the 1953–54 recovery, did a large capitalization category lead.

Consistent with this record, small value has led in the present recovery so far, and by a wide margin, too.

Now that the economic recovery has gained some momentum, investors, quite naturally, have begun to ask whether recent leadership by small capitalization value stocks will persist.

If history is any guide, the answer is "Yes."

The averages show clearly that small growth leads out of recessions, with a 1-year average return of +48.2% for all 10 cycles, excluding the present, incomplete one. Small value comes in second, with an average 1-year return of +43.3%.

Chart Courtesy of www.StockCharts.com

Ominous Divergence Implies Caution

Charts courtesy www.StockCharts.com

The Dow Jones Industrials ($INDU), a proxy for blue chip stocks, closed at a new weekly cycle high (10,318) on Friday, November 20.

The Russell 2000, a proxy for the small-cap sector, posted a weekly close at 585, which was -5.1% below its Friday, October 16, 2009, close at 616.

That's not what we like to see. If blue chips are making new highs and small cap stocks are not, it creates a negative divergence, a non-confirmation that typically signals an end to an intermediate-term rally.

The healthiest stock market rallies occur when all of the major sectors and indices capture new highs in concert. When they don't, it typically signals that stocks will correct and/or begin moving in a sideways range.

And the most profitable and least risky rallies occur when small-cap stocks lead. That's because small-caps are considered the riskiest of the three capitalizations (large-cap, mid-cap and small-cap). And when investors are willing to bid small-cap stocks to new cycle highs, they are confident that the stock market and the economy are healthy enough to support one of the riskiest areas of the stock market. 

Other key sectors that DID NOT confirm the weekly new cycle high on Friday include the bank, brokerage, financial and semiconductor stocks.

Until these sectors and the smallcaps post new cycle highs along with the Dow Jones Industrials, the odds are high that the stock market will undergo a correction.