How to Build a Weight of the Evidence off Market Lows, Small Cap Edition
Small cap names have been no stranger to weakness over the last few years. Since the start of 2023’s bull market, representative IWM has advanced merely 19.88% through 6/3/25, vastly underperforming SPX which is up roughly 56% over that same time frame. The near 35% underperformance has certainly had an impact on the technical posture of the space. IWM hasn’t held a “Strong” (>=4.0) NDW fund score since late 2021. Compare this to S&P 500 representative SPY which has largely scored around that 4.0 point for the better part of the last two and a half years. Regardless, up roughly 17% off 2025 lows, the improvement has been notable enough to warrant a review.
This underperformance for small caps is nothing new, but we will open today’s feature with a crucial reminder: Absolute improvement does not always precede relative improvement. It can be quite easy to look at the default chart for IWM above, note the trend break and think you are getting in on the ground floor of a brand new small cap bull market. This is quickly shot down when looking at a simple 1 to 1 arm wrestling contest between SPY & IWM, evidenced below. Despite improving on its own, the relative perspective has in fact worsened since April, suggesting attempts to stray from the core into small caps have been largely unproductive. SPY maintains a buy signal and column of X’s against IWM suggesting large caps continue to earn both long and short term strength against their small cap counterparts.
If the top-level view tells us one thing, the next step the analyst team typically endeavors in is to peel back the layers of the onion to properly diagnose the situation. In most cases, there are relative bright spots, even in weak asset classes/sectors one could look towards. With respect to small caps, that isn’t immediately the case… using the SPDR sector funds and Invesco small cap sector suite as proxies, no small cap option outscores its large cap counterpart via NDW’s fund scoring system. Furthermore, only one small cap option scores above the technically acceptable 3.0 mark, that being PSCI. All this to say, the lack of strength within the small cap space is quite interesting, at least when it comes to long-term strength. Similarly to the basic RS chart between SPY and IWM above, the table below details the each large cap representative against their small cap counterpart on a 3.25% RS scale. In 10 of the 11 sectors, the large cap representative sits in a column of X’s against the small cap proxy (sans healthcare,) speaking to the strength of recent upside action. Nine of the 11 sit on long-term buy signals, the lone outliers being previously mentioned industrials and healthcare. It is worth noting that most, but not all, of these RS tests are historically consistent, yielding profitable signal switching strategies.
While momentum focused strategies haven’t had the easiest go of the small cap landscape so far in 2025, we will close today’s piece with a brief aside discussing the prospects of trend following within the space. As we typically do, we can run a spread between a basket of “winners” & “losers”, what we call an “RS Spread.” The greater this number/value, the greater the chances momentum focused strategies will be able to attach themselves to strong options and distance themselves from weak ones. Unlike that on the domestic or international front, the spread within small caps has waned as leadership trends have seen some chop… but the spread (chart on the left) doesn’t tell the full story.
Zooming in further to the chart on the right, we can look at the performance of different small cap deciles coming off of 2025 spread lows (defined at 4/4/25). High relative strength names have actually done quite well, second only to the severe laggards of the group which have rocketed higher throughout the recent advances… hence the lack of genuine movement in the overall performance spread in the chart above. If these small cap leaders can sustain their upside action and the laggards can go back to lagging, the backdrop for a stronger momentum market on the small cap front becomes a bit more clear as we wrap up Q2.
