What’s Wrong with Small Caps?

Written by John Lounsbury

For the first 30 months after the secular bear market low of March 2009, small caps consistently led the way.  In most of the year that followed, from August of 2011, the highs and lows of the three market indices, S&P 500, Nasdaq 100 and Russell 2000 have continued to move up and down pretty much in lock step, but with the S&P 500 assuming the leadership role.  That lock step behavior appears to have changed since the end of June.  Since the high for Russell 2000 on July 3, both the S&P 500 and the Nasdaq 100 large cap indexes have continued to advance but the small cap Russell 2000 index has traded down.

The three did trade down by similar amounts until July 12, but since then the two large cap indexes have been much stronger, trading up between 5% and 6% while the Russell 2000 is up only about 1/4 as much and is still below its July 3 closing high.

The divergence since the high for IWM at the beginning of July (and especially since July 12) for the three major indices, represented by SPDR ETF for the S&P 500 (NYSE:SPY), Powershares ETF for the Nasdaq 100 (NASDAQ:QQQ) and iShares ETF for the Russell 2000 (NYSE:IWM) can be seen in the first graph below.

Click on graphs for larger images.

The closest thing to the current behavior during the past 3 1/3 years occurred for about four weeks late August into September last year when IWM traded down, QQQ traded sideways and SPY traded up.

The behavior this year is different:  In the last four weeks both SPY and QQQ have traded up while IWM has declined.

To gain an appreciation for what is significant about the current behavior, let’s look at a longer-term view of the three ETFs all the way back to 09 March 2009:

Click on graphs for larger images.

The 11 peaks in IWM that preceded declines of approximately 15% or more are marked with “X”. The two periods where a significant divergence occurred for IWM with either or both of the other two ETFs are outlined with red boxes. The most recent event has the IWM peak marked with a question mark because that decline either (1) is not yet completed or (2) will prove to be only 6%. IMW need only rise above 81.53 (less than 1.37 above Thursday 09 August close) to exceed the closing high on July3 and remove the question mark.

But whether the high for IWM on July 3 becomes a top defining the start of a 15% or more decline or not, the more important question is whether the large cap indices continue to pull away from the Russell 2000. The longer this continues the more investors should be reducing exposure to small caps. The other factor is the observation that small caps often lead bull markets until they mature but then underperform as the large caps top out. The longer this underperformance for IWM lasts the more likely that the end of the great bull market from 2009 is near, or, at least that a significant correction (20% or more) is imminent.

The plan for the coming weeks:

1. Keep checking the charts for SPY, QQQ and IWM.

2. As long as SPY and QQQ both perform much better than IWM, keep lightening up on small cap stock exposures.

3. If one of the two large cap ETFs outperforms the other in addition to IWM, reduce exposure in whichever large cap index is failing behind as well as small cap stocks.

4. If all three ETFs decline at the same time, lighten up on stocks in general and start monitoring for bargain stocks that you may be able to pick up at lower prices down the road.

Note: This strategy reflects my own personal investment style which is not one of going all in or all out quickly. How other investors would react to the same information depends on their individual investment styles.

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