MW These stocks are lagging the S&P 500's record rally. Is it a red flag for markets?

By Isabel Wang

The underperformance of small caps and discretionary stocks is not a reason for investors to reduce exposure in U.S. equities, says SentimenTrader

Economically sensitive stocks - particularly small caps and consumer-discretionary names - have lagged the broader market as the three major U.S. stock indexes have fought to reclaim record highs.

At first glance, that might look like a red flag for the market's record-setting run, because small caps and discretionary stocks usually participate in a strong market rally when the economy is in solid footing.

A look beneath the surface, however, suggests that this has not historically been a consistent reason for concern, according to SentimenTrader.

While the large-cap S&P 500 index SPX hit a record high in late June for the first time in four months after recovering from a 15% drawdown in April, shares of small-cap companies and consumer-discretionary stocks have lagged. As of June 27, the S&P 500's consumer-discretionary sector XX:SP500.25 was down nearly 10% from its all-time closing high on Dec. 17, while the Russell 2000 small-cap index RUT had declined 6.3% from its own peak on Jan. 21, according to Dow Jones Market Data.

Unlike megacap technology names, small-cap companies are more vulnerable to higher interest rates and economic downturns, as many of them rely on debt for their operations and growth. Stocks in the consumer-discretionary sector are also sensitive to the health of the economy, since they depend on consumers' willingness to purchase nonessential goods and services when the economy is resilient.

See: The stock-market rally is broadening beyond Big Tech. Will consumer stocks bounce back in the second half of the year?

To be sure, there have been only three historical precedents since 1926 where the S&P 500 reached new highs following a 15% decline while both small-cap and discretionary stocks remained more than 5% below their peaks. That's too few to draw any firm conclusions, according to Jason Goepfert, senior research analyst at SentimenTrader.

Meanwhile, in none of those instances did the stock market experience a significant downturn over any time frame, Goepfert said.

History shows the S&P 500 has averaged a 2.7% increase in the month after the S&P 500 reached fresh records following a 15% decline, while both small-cap and discretionary names lagged. The large-cap index has also registered an average advance of 6.1% over the subsequent six months following that exact same setup, according to data compiled by SentimenTrader.

The results remain consistent even when expanding the sample size to include smaller drawdowns in stocks.

Since 1926, the S&P 500 has still remained largely resilient in the periods after recovering from a more than 10% drawdown while both small caps and discretionary stocks were at least 3% off their record highs.

"The S&P 500 sported a healthy average return across time frames, with a decent risk/reward ratio over the following year," Goepfert said in a Monday client note.

Among the S&P 500's 11 sectors, discretionary stocks have delivered some of the strongest returns over the following four to 12 months of that setup - suggesting "some tendency for mean reversion" relative to other stock sectors that had performed better leading up to the new highs in the S&P 500, Goepfert said.

See: U.S. small-cap stocks have been playing catch-up for years. Don't expect that to change anytime soon, analyst warns.

Stock-market investors have long raised concerns about the lack of broader participation in the market's recent record-setting rally, but the story still varies by sector.

"It pays to investigate when claims are made that a breakout may not last for whatever reason, especially if that makes theoretical sense, like the disturbing message that lagging small-cap and discretionary stocks might send," Goepfert said. However, history says there is no reason to reduce exposure in U.S. stocks "due to those lagging factors alone," he added.

U.S. stocks were modestly higher on Monday after President Trump announced additional tariffs of 30% on the European Union and Mexico over the weekend. The Dow Jones Industrial Average DJIA was rising 0.1%, while the S&P 500 was up 0.2% and the Nasdaq Composite COMP was advancing 0.4%, according to FactSet data.

-Isabel Wang

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July 14, 2025 15:49 ET (19:49 GMT)

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