May 14, 2014 / 2:08 PM / 5 years ago

Investors fear small-cap woes may spread through Wall Street

NEW YORK (Reuters) - The S&P 500 .SPX is near record levels but recent weakness in small-capitalized stocks is keeping investors awake at night.

Traders work on the floor of the New York Stock Exchange March 17, 2014. REUTERS/Brendan McDermid

The Russell 2000 .TOY index of small-cap stocks has struggled of late as investors pull away from Internet retailers, biotechnology and other names with hefty valuations.

Generally, the two indexes tend to track each other. When small-caps get in trouble, a sell-off in the big names is usually not far off. Small-cap stocks are looked at as a proxy for growth expectations, and when they start to flag, it’s a sign of concern about the economy.

“You want to see both the S&P and Russell hit new highs as that’s confirmation of broad-based strength,” said Ari Wald, head of technical analysis at Oppenheimer in New York. “Instead, we’re seeing fewer daily 52-week highs, which is an important indication of how strong internal breadth is.”

Wald said if the Russell falls decisively under 1,082.73, its 2014 intraday low, that could result in a flurry of broad selling and “prompt a correction of 6 to 8 percent in the S&P.”

Historically, divergences between the S&P and Russell have been short-term negatives for the benchmark index. According to Sundial Capital Research, when the S&P hits a 52-week high while the Russell is more than 5 percent below its own top, the S&P on average falls by 2.1 percent over the next month.

The Russell index currently sits 8 percent below its peak. The S&P closed at a new high on Tuesday.

Options activity suggests more weakness in small-caps. For every 100 calls purchased on Tuesday, investors bought 192 Russell puts, which are contracts used to bet on a fall in a security or a hedge against a decline.

The ratio “suggests that people generally seem to be expecting more bearish action,” said Randy Frederick, managing director of active trading for Charles Schwab in Austin, Texas.

However, the Russell’s decline may be related more to valuation concerns for the small-cap index. The Russell’s price-to-earnings ratio is higher relative to the S&P 500’s than it has been over the past 35 years, according to Citigroup Global Markets. Over the past 10 years, the Russell’s total return is 133.8 percent, while the S&P’s total return is 113 percent.

“We’ve been moving to large caps for the last six months because of the valuation divergence,” said Channing Smith, co-portfolio manager of Capital Advisors Growth Fund in Tulsa, Oklahoma. “The sell-off in the Russell will probably continue as people de-risk out of small caps and migrate to larger, safer names like we’ve been doing.”

Funds tracking the Russell saw outflows of $3.9 billion over March and April, according to Thomson Reuters’s Lipper service. Large-cap funds saw inflows of $6.48 billion during that time.

Editing by Bernadette Baum

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