Volatility In Small-cap Stocks Will Eventually Disrupt The Calm In Large-cap Indexes - Economic Highlights

Pre-open sentiment is pointing to a positive open for stocks, but trading volumes will most likely be even weaker by this week's low standards ahead of the Memorial Day weekend. Stocks made decent gains this week and the trend will likely continue in today's session as well, though low volumes have a way of exaggerating any price action.

Measures of volatility have really come down in recent days. But unlike the calm in the broad large-cap indexes, the world of small-cap stocks is anything but calm. The Russell 2000 index, the benchmark index of small-capitalization stocks, is down close to -6% year to date and was down briefly more than -10% from its peak. The S&P 500 index is in positive territory year to date and remains close to its all-time high. The Russell is small relative to the S&P 500, accounting for about 11% of the large-cap index's market capitalization and expected to bring in about 6.4% of the S&P's total earnings in 2014.

We know how weak the earnings performance of the S&P 500 index has been in Q1, with total earnings up only +1.2% for the 489 S&P 500 members that have already reported results. The earnings picture is actually even weaker in the small-cap space. With Q1 results from 91.8% of the Russell 2000 already out (1834 companies), total earnings for the index are down -4.8% and only 41.2% of the companies have come ahead of earnings estimates.

Top-line growth is better, up +6.4%, but only 37.1% of the companies have beat revenue estimates. This compares to earnings growth of +10.4% for the same group of companies in 2013 Q4 and the 4-quarter average of +12.2%. A very weak performance anyway you look at it.  

Small-cap stocks in general and the Russell 2000 index in specific represent the domestic-centric vanguard of the corporate world – the Russell stocks are always ahead of their large-cap peers in responding to sentiment shifts in either direction and are excellent barometers investors' risk appetites. As such, developments in the small-cap space could be interpreted as the leading edge of the broader market. Looked at this way, the small-cap turmoil will be expected to eventually disrupt the large-cap calm. We will have to wait to find out.

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