Forget Dow 17,000. This Index Holds the Key to the Bull Market's Future

Throughout the holiday weekend, you'll hear about how the Dow Jones Industrials (DJINDICES: ^DJI  ) rose above the 17,000 level for the first time, marking the third time in a little more than a year that the Dow has set a new thousand-point milestone. Yet, even as the Dow soars into uncharted territory, another stock market index is approaching an all-time high of its own. If the small-cap Russell 2000 (RUSSELLINDICES: ^RUT  ) reaches new record levels, it would be an important indicator of just how deep the positive sentiment investors have toward the stock market actually goes.

What's at stake with small-cap stocks
Given all the new record highs that the Dow Jones Industrials, the S&P 500 (SNPINDEX: ^GSPC  ) , and other large-cap stock indexes have set during the past quarter, it might come as a surprise that the Russell 2000 has been left out of the celebration. Since hitting its all-time record high on March 4, the Russell 2000 has languished, coming far closer to suffering a full 10% correction in May than the Dow has in 2013 or 2014.

^DJI Chart

Market data by YCharts.

During the Russell's decline, market analysts argued that small-cap stocks were lagging behind their large-cap counterparts because of the prospects of future economic obstacles. Smaller companies often perform best during the initial stages of an economic recovery, as they have the ability to maneuver nimbly to take advantage of growth opportunities more quickly than large companies do. As bull markets age, though, large-cap stocks often catch up and surpass their smaller peers, and small-cap stocks also struggle in tough times as they lack the greater financial resources that large companies have.

On Thursday, though, the Russell 2000 came within half a point of setting a new all-time record high. If the Russell can break through into record territory, it would inevitably have a positive impact on the philosophy of short-term traders, who pay close attention to convergences and divergences within the different corners of the stock market.

Perhaps more importantly, though, the recovery in the Russell reflects the fact that fundamentals for many smaller companies remain strong. One reason why the spring correction for the Russell 2000 was so dramatic was that small-cap stocks sport higher earnings multiples than their larger peers, reflecting greater expectations for long-term growth. Any threat to that growth can create big swings in share prices, but small caps also usually give shareholders greater returns during upward-moving markets when they actually reach their full potential.

What to watch for from small-caps
As earnings season starts next week, most investors will look at the largest companies and their quarterly reports. But astute investors should look deeper, and focus instead on some often-overlooked smaller companies. If they can do as well as, or better than, their large-cap competitors, then the recovery in small-cap stocks could be just the beginning of a new bull-market run for the Russell 2000.

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  • Report this Comment On July 05, 2014, at 3:16 AM, Randy4t2 wrote:

    I have scattered thoughts tonight...In my opinion, small-caps is where the market will take it's leadership now. I have bought fairly heavily when small-caps dropped or "corrected" or near corrected over the past year and the payoff has been tremendous. The present high was tested a couple of times, but now with the correction behind us we will see small caps set new highs even as the Large caps correct. Those who do their homework will be the winners. When not sure which to buy, buy the Russell 2000 index. One historically true fact is when the fund managers start sitting on high cash reserves, the market usually goes up and the small caps accelerate. Lesson to be learned? You won't be rich by following the majority. The majority are usually wrong....as fund managers go, that is. When they are betting for a drop, I get ready for a nice gain. Of course, nobody is wrong all the time, even the majority will make gains. But those who get on the train last miss the thrill of the whole ride up. Lastly, whenever I incurred losses over the years, small-caps always gave me my recovery. So, I'm a BIG fan of them. I have been over the past year...and I'm still buying regularly.

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