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

Looking beyond the Dow is important to get perspective on the market as a whole.

Dan Caplinger
Dan Caplinger
Jul 4, 2014 at 11:02AM

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.