Some investors think of small-caps as the market “runts”—the “97-pound weaklings” of the stock market universe. But you may want to think twice before you kick sand in the faces of these little guys.
As it turns out, small-caps, as a group, can act as a powerful leading indicator, warning traders and investors of imminent trend reversals.
They can give us a “heads up” when bull markets are edging into downturns, and again when bear markets are gaining strength to rise into new uptrends.
Before we dive into our analysis, know that the term “small-caps” is market-speak for “small capitalization stocks.” That means the companies within this group, have a market capitalization of between $300 million and $2 billion.
(Market capitalization = the price of the stock multiplied by the number of shares outstanding.)
We can target indexes to measure small-cap performance. The best known are the S&P 600 Small Cap Index and the Russell 2000 Index. The Russell 2000 Index is the best known; it updates its nearly 2000 components annually each year at the end of June.
The easiest way to track the Russell 2000 Index is to observe the iShares Russell 2000 ETF (IWM).
The IWM represents a well-diversified basket of small-cap stocks that targets all ten S&P 500 sectors: 24.52% to financials, 16.60% to information technology, 16.47% to health care, 14.72% to consumer discretionary, 12.71% to industrials, 3.91% to materials, 3.61% to energy, 3.34% to utilities, 3.07% to consumer staples and 0.82% to telecommunications. A small portion, 0.24%, of its fund is allocated to cash and/or derivatives.
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Now, how can the IWM act as a potential guide for upcoming broad market action? First, the companies in the IWM are generally U.S.-centric; that is, most are based in the U.S. and serve local businesses. Thus, their earnings and outlooks are highly tuned-into the U.S. economy.
When the U.S. economy speeds ahead on all cylinders, small caps generally thrive. But if our economy begins to stumble, so do small-caps. And they usually feel the “pain” before the large cap multinationals.
Second, caps are sensitive to the interest rate environment. Unlike their large and mid-cap siblings, who can enjoy large cash holdings, most small-caps are forced to borrow money to grow. Rising interest rates have an impact on small-caps’ ability to borrow and expand.
Here’s another way to look at it: Imagine the S&P 500 large-caps as the “generals.” Think of the Russell 2000 small caps as the “soldiers.” If the generals are marching into war, and the soldiers happily follow, then that war project will go forward.
But, if the generals head onto the battlefield, and the soldiers refuse to follow, then that war project is not going to take place—or at least not successfully.
Now let’s take a look at the current price comparison between the SPDR S&P 500 ETF (SPY) and the IWM. Please note that on the weekly chart below, the green line represents the SPY and the red line represents the iShares Russell 2000 ETF (IWM).
Chart courtesy RealTick ®
As you can see, during 2013 and the first half of 2014, the IWM (red line) outperformed the SPY. But during the second half of 2014, the IWM faltered, dipping below the SPY and losing a portion of its mojo. That was our indicator. It signaled that as long as the IWM traded at a material discount to the SPY, weakness could infect the market going forward.
From the opening bell on Jan. 4, 2016, until its final relative low on Feb. 11, the IWM plunged 15% (the SPY fell 9%). Since then, it has underperformed the SPY, telling us that the soldiers (IWM) are having a difficult time following the generals (SPY) onto the battlefield.
If the IWM can trend higher from here, then perhaps over time, it can catch up with the SPY. If, however, the IWM moves lower as we head into the last weeks of April, then I will be more cautious in my approach to the overall market.
As traders and investors who want to know where the market is headed next, we would be wise to keep an eye on the IWM. Far from 97 pound weaklings, this group holds the power to give us a “heads up” for upcoming market direction.
Until next time,
Toni Turner is the President of TrendStar Group, LLC, is an accomplished technical analyst as well as a popular educator and sought-after speaker in the financial arena.
She is also the author of best-selling books: A Beginner’s Guide to Short-Term Trading, Short-Term Trading in the New Stock Market and Invest to Win: Earn and Keep Profits Bull and Bear Markets With the GainsMaster Approach, co-authored with Gordon Scott, CMT.