Underperformance of Small Caps Suggests Higher Volatility May be Around the Corner

The S&P SmallCap 600 has underperformed the S&P 500 by roughly 4% over the past month. This could be an early indicator that volatility, represented by the VIX, could soon increase. As the first chart below illustrates the relative performance of small caps against large caps has had a pretty strong negative correlation to the level of the VIX since the financial crisis. Said differently, when small caps underperform large caps the market has tended to see in increase (and in many cases a spike) in the VIX. The weakness isn’t just in small cap stocks either. The Russell 3000, which comprises 98% of the market capitalization in the US, has turned over once again relative to the S&P 500. The relative performance of the broad US stock market compared to the S&P 500 has also had a fairly strong negative correlation to the VIX since 2008.