The return of high-flying growth stocks has stolen the show this year.
The NASDAQ Composite, which lagged throughout all of 2022 and ended the year 35% from its all-time highs, has risen more than 11% in 2023. That far outpaces gains in the value-oriented Dow Jones Industrial Average (+0.7%) and the benchmark S&P 500 Index (+5.4).
Slipping under the radar, though, have been small cap stocks. They’ve quietly gained 9.8% to start the year, and that run of outperformance could continue. Compared to the S&P 500, the Russell 2000 bottomed last May.
It’s been all higher highs and higher lows since then.
Last year’s back half outperformance was largely attributable to differences in sector weights. The Russell 2000 has more exposure to Financials, Health Care, Industrials, and Energy, (all areas that outperformed) and is underweight Communication Services and Tech (sectors that lagged).
But that isn’t the story this year. On a like-for-like basis, small caps have simply been better.
The S&P 500, Dow Jones Industrial Average, and Nasdaq are each within a few percent of their all-time highs, yet for the last 6 months, stocks have struggled to break through overhead resistance with any conviction. The Cumulative Advance/Decline Line indicates that breadth is at least adequate, and sentiment readings are far from stretched, but still, prices remain largely stagnant. One problem could be a lack of risk appetite. Strong equity uptrends are generally a reflection of increased risk-taking from investors, and ratio analysis is a great tool for gauging the appetite in the current environment.
The debate over Growth and Value has dominated the investment landscape for decades. Growth stocks certainly led the way higher during the dot com rally of the late 1990s, but then led on the downside as the bubble popped. The tendency of Growth to outperform during uptrends has been apparent in recent years as well.
The ratio of S&P 500 Growth to S&P 500 Value rallied from 2013-2015 as stocks broadly advanced, but then declined from late 2015-2016, a period where equity markets struggled to set new highs. Growth bottomed relative to Value at the end of 2016, and stocks soared in 2017. The ratio climbed all the way through the Dot Com high of 1.57, but then stalled at the 261.8% retracement from the 2015-2016 decline. The August decline confirmed a bearish RSI momentum divergence and got to its most oversold level since 2016.
In short, this multi-year trend of Growth outperformance is on life-support. The ratio needs to work off its momentum problems and recover the 2000 highs, or this false breakout could be just the start of Value’s strength.
Other flavors of domestic equities are showing a lack of risk appetite as well. Simply comparing the Consumer Discretionary sector to Consumer Staples yields similar results to those above. This ratio is great because it just makes sense: the numerator is the equivalent of buying a new car, and the denominator is buying toothpaste – people are only doing the first when times are good.
Like Growth/Value, Discretionary/Staples made it all the way back to 2000 highs in 2018. But the ratio put in a bearish momentum divergence in the third quarter of that year and has struggled ever since. Momentum is stuck in a bearish range, and the current ratio is below its 200D moving average. While clearly not in an uptrend, we’ll have to see a break of last year’s lows to get more negative on this relationship.
Small cap stocks relative to large caps have moved sideways for much of the last 5 years. A strong 2016 was followed by weakness in 2017, but the period since mid-2018 has been especially weak.
Momentum, too, has been decidedly negative since March, and not even a sharp September rally could break the ratio’s downtrend. Support from the 2007-2009 lows, just above 0.50, is a logical place to try and find a bottom, but for now the trend is down.
Looking abroad, the ratio of Emerging to Domestic markets is another great measure of risk-appetite, and it’s sending a similar message. The false breakdown in early 2016 was a near-perfect indicator of the bottom in U.S. equities, and four years later we’re back to the same key level. The 2019 downtrend is very much intact, and momentum has been stuck in a bearish range for most of the year. Technicians argue that the more times a level is tested, the more likely it is to break. This is the fifth (sixth?) attempt to get through 0.70 – a breakdown here would be point towards further risk aversion by investors.
On the other hand, momentum diverged positively at both the July and August lows, and has yet to get oversold during the September decline. We’ll want to see a bounce and break of the most recent swing high to confirm the divergence, but a bounce off of multi-year support might make some sense.
Risk aversion hasn’t been limited to equities either. The bond market is significantly larger, and investors have favored Investment Grade Corporate Bonds over their riskier counterparts since the fall of 2018.
High Yield bonds took the brunt of the 2015-2016 decline in stocks, but then ripped higher over the next three years. When stocks began to fall again in October of last year, High Yield began to to underperform, too. In August, the ratio fell below the 2014 swing high – a sign of more bad things to come. But buyers came to the rescue and pushed the group back above the key support level. Momentum even managed to get overbought on the recent rally, but the ratio has more work to do. It’s still below a downward sloping 200D moving average and the downtrend line from the highs. The false breakdown might have been the key turning point, but we’ll need to see more bullish evidence before calling this a broken downtrend.
For stocks to move higher, we’ll probably need to see more appetite for risk in the markets. The safety trades have clearly been in control, but several of the relationships above could be at bullish turning points. More concerning would be a loss of leadership from Growth stocks, which had managed to lead even as the other ratios faltered. However things resolve, the next few weeks should be fun to watch.
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