Looking from a distance, the US stock market looks placid. The S&P 500 index reached all time highs and volatility is low. After the sell-offs in 2020 (due to Covid) and 2022 (due to a rise in interest rates), equities are behaving well.
The recent quiet is obvious from a chart of daily returns on the S&P 500 index. In 2020, returns were all over the place, with multiple days when the index moved up or down by more than 5%. The sell-off in 2022 was more orderly. Only one day saw a return over 5%, and there were no returns below -5% (a few came close, though).
In contrast, the years 2021 and 2023 saw a tighter range of returns, and 2024 has had no big moves so far. The lowest return has been -1.6% and the highest return 2.1%.
There is more to the market than the S&P 500 index, however. Below the surface, there has been considerable turmoil during the month of July.
Most of the time, stocks all move more or less in lockstep. That is not the case now. Since the beginning of July, large-cap tech stocks which have been powering the market up to now have started selling off. At the same time, small cap stocks moved up violently after lagging behind for years. The disconnect between their performance is off the charts.
Looking at 40 years of data, we found only four examples of similar or greater magnitude. They came on two occasions.
The first was the Black Monday sell-off in 1987 when the S&P 500 collapsed by 23% on Oct. 19th. Interestingly, the spread between the Nasdaq and small cap stocks was a warning sign. The two weeks ending on October 18th saw a return spread of 10%. The spread widened even more after the crash, posting a historic level of over 20% in the next two weeks.
The second occasion was the bursting of the dotcom bubble. The Nasdaq peaked on April 9th, 2000 after an unprecedented and nonsensical run-up in valuations, the likes of which we thought we would never see again. That week and the one that followed saw 18% outperformance of small cap stocks over large cap tech names. This signal rang the bell on the dotcom bubble and marked the beginning of a vicious bear market in tech stocks. The Nasdaq fell 77% from its peak in April 2000 to its bottom in October 2002. Along the way, it managed to post another 12% return spread below small cap stocks in December 2000, just to let everyone know that the bear market wasn’t over yet.
| Nasdaq minus S&P 600 Small Cap | |
| Biggest 2 week spreads since 1984 | |
| Two weeks ending | Return spread |
| November 1, 1987 | −20.43% |
| April 16, 2000 | −18.11% |
| December 24, 2000 | −12.38% |
| July 21, 2024 | −10.24% |
| October 18, 1987 | −10.03% |
The level of outperformance of small cap stocks over large cap tech that we saw in July is rare. It has been matched or exceeded only 0.3% of times in the last 40 years. And each of those times preceded major turmoil in the overall market.
Do not be misled by the placid performance of the S&P 500 index. All is not well.
