The Dow Might Be Calm, but Small Caps Are Anything But

On Wednesday, the Dow Jones Industrials (DJINDICES: ^DJI  ) fell 102 points, responding to calls of weaker global economic growth and political uncertainties in the wake of the primary loss of the majority leader in the U.S. House of Representatives. Even so, the Dow has continued to be a bastion of stability, refusing to turn declines into outright routs and generally tracing a gentle upward slope throughout the past several months. For the Russell 2000 (RUSSELLINDICES: ^RUT  ) and small-cap stocks, however, volatility has been a much bigger concern lately, and some believe that the small-cap index's failure to match the record closes in the Dow Jones Industrials could spell an end to the bull market.

Reversal of fortune
The outperformance of small caps from earlier in 2014 has given way to underperformance since the beginning of the second quarter:

DIA Chart

Stock market data by YCharts.

More tellingly, small-cap indexes have seen much more extreme moves in the recent past than their large-cap counterparts. In the past four weeks, the Dow has failed to move by more than 1% in any single session, but the Russell 2000 has seen 1% moves in both directions, with big moves coming on six separate occasions.

Part of the concern about small caps has come from the fact that they've outperformed the Dow to such a large extent over the past five years:

IWM Total Return Price Chart

Stock market Total Return Price data by YCharts.

As impressive as the Dow's overall gains have been over that timeframe, small caps have done even better. That made sense early in the recovery as small caps had fallen further than their large-cap rivals. But as the bull market aged, small-cap outperformance indicated the continuing belief that nimbler companies could take better advantage of favorable conditions for growth than bigger companies and their greater levels of bureaucracy.

What's next?
If economic growth does indeed slow, then historically, that has led to large-cap outperformance over small caps. Small companies don't have the same resources to work through tough times that large companies have, and the market-share advantages that many large companies have over their smaller rivals tend to last longer when customers who face economic pressures of their own prefer to keep the status quo rather than taking chances with major operational changes. As a result, if the World Bank's predictions prove correct, then the recent small-cap weakness could continue.

Nevertheless, that doesn't mean that the Dow Jones Industrials are doomed to an immediate correction or bear market. In past economic cycles, large caps often enjoy a period of solid returns even when small caps start to let up on the pace of their gains. As unsatisfying an answer as it might be, investors need to stick with making smart choices about individual stocks if they want to find ways to avoid increasing turbulence with the major market indexes.

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