Are emerging small-cap stocks signaling a new risk environment?

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The relationship of small-cap to large-cap stock prices is a noted indicator of risk appetite in the broad U.S. equity market. We can extend this logic to emerging markets as well. As followers of my approach to intermarket analysis are aware, I focus on relative performance to get a sense of where the crowd is positioning most aggressively at any moment in time. I prefer this approach rather than relying on investor sentiment surveys because it shows where money is going and not so much what people are saying: actions speak louder than words. One relationship in particular I like to focus in on is the relative performance of small to large-cap stocks. For example, when the small-cap Russell 2000 ( IWM , quote ) outperforms (up more/down less) the large-cap S&P 500 ( SPY , quote ), it means investors are comfortable with taking risk. After all, small-cap stocks tend to have higher beta and higher market sensitivity and are less liquid, which means traders will have to accept positions for longer periods of time -- likely only when there is a growing sense that the economy and world financial system are improving. Take a look at the price ratio of the SPDR S&P Emerging Markets Small-Cap ETF ( EWX , quote ) relative to the iShares MSCI Emerging Markets ETF ( EEM , quote ). As a reminder, a rising price ratio means the numerator/EWX is outperforming (up more/down less) the denominator/EEM.

We can clearly see that the ratio peaked out in late 2010 and weakened substantially throughout 2011. However, sometime around the middle of December a bottom looks to have occurred, with a significant period of outperformance occurring in a powerful uptrend of leadership. If U.S. small-cap stocks are less liquid than their larger counterparts, this is even more true for emerging small-cap shares. For these relatively illiquid asset class to come back so sharply, some serious "risk on" positioning must be occurring overseas. Interestingly enough, the move can not be attributed to any single stocks. The top three holdings in EWX are Kulim (Malaysia) BHD, Lewis Group LTD and Thanachart Capital, but combined they make up only about 2.25% of the fund. The bottom line is that the above ratio continues to confirm the very real idea that 2012 can be a year of reflation similar to 2003 and 2009, as I've been stressing in my writings . Risk appetite has come back in a stunning way. Go EEM, go.

by Michael A. Gayed CFA for Emerging Money

The author, Pension Partners, LLC , and/or its clients may hold positions in securities mentioned in this article at time of writing. The commentary does not constitute individualized advice. The opinions herein are not personalized recommendations to buy, sell or hold securities.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.