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Are Small Companies the Market’s Achilles Heel?

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The performance of U.S. stocks over the past four years has been like the 1960s Boston Celtics: Dominant, unbeatable and just plain extraordinary.

During this span, the S&P 500 (SPY) has led the way with a 74.34% gain, while the S&P MidCap 400 (MDY) increased +64.27% and the S&P SmallCap 600 (IJR) jumped +71.48%.

Despite the sizzling historical performance for U.S. stocks, the recent underperformance of smaller stocks could be a signal of broader stock market weakness ahead.   

The year-to-date (YTD) performance for large-, mid- and small-cap U.S. stocks is still marginally up (between 1.5% and 2.9%), yet over the past three months, performance is deteriorating and negative for all three groups.

Losses in mid-cap and small-cap stocks are in the 2% to 3% range, whereas larger stocks are holding up better. More importantly, the fact that mid- and small-caps are now laggards is a signal that risk appetite for smaller and riskier companies is waning.  

Over the past several weeks, market technicians along with the Technical Forecast published by ETFguide have observed that stock market breadth is poor. On the NYSE alone, almost 60% of stocks are trading below their 200-day moving average, which tells us that most stocks are in a downtrend.

Here’s another problem: Fewer stocks are participating in the rally. Just five companies – Apple, Amazon, Google, Facebook and Disney – have contributed 61% of the S&P 500’s year-to-date gain, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. In a healthy bull market, more stocks should be lifting broader indexes.

The Vanguard FTSE Emerging Markets ETF (VWO) has tumbled almost 15% over the past three months, led by the 18.94% crash in Chinese A-Shares, as tracked by the Deutsche X-Trackers Harvest CSI 300 China A-Shares ETF (ASHR). Could higher volatility in overseas securities be a prelude of what’s ahead for U.S. stocks?

Interestingly, the lack of significant pullback hasn’t held back the performance of defensive sectors like consumer staples (XLP), which have performed better than the broader S&P 500 thus far this year. Typically, defensive sectors will underperform when the general market is rising.

Is demand for safer stocks yet another warning sign of turbulence ahead?

As always, the stock market always leaves us with more questions than answers. But we shouldn’t forget nor ignore market history.

Going back to 1949, the previous 10 bull markets had an average duration of 1,770 calendar days and produced gains of 161.4%.

Through the July 31 market close, it’s been 1,400 days since the S&P 500’s last 10% correction. That means the current bull streak will need to continue through August 2016 to match the average length of previous bull markets.

But it’s doubtful that feat can be accomplished without the help of midsize- and small-company stocks.

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Ron DeLegge’s is the founder and chief portfolio strategist of ETFguide.

—Check out Icahn, Fink Clash Over Junk Bonds on ThinkAdvisor.