The recent relative weakness of small caps in general — and the Russell 2000 in particular – isn’t just a figment of investors’ imaginations. Since March 5th, the iShares Russell 2000 Index ETF (IWM) has tanked 8.5%, while the SPDR S&P 500 ETF Trust (SPY) has eked out a small 0.7% gain. Take a look:
It’s no small disparity, but more than being a fascinating divergence, it’s also a red flag for market veterans. See, bear markets tend to start with the deterioration of small caps, which are seen as more aggressive yet also more vulnerable to economic weakness than large caps.
If it is indeed the beginning of a bear market, large-cap stocks should sooner or later follow that lead and join small caps in bear market territory. So, the recent tumble of IWM against a backdrop disappointing earnings reports is just problematic enough to cast a shadow of doubt on U.S. stocks.
The obvious solution is to get out of U.S. stocks, or dump ETFs like SPY or IWM, before the impending bear market can do any real damage to domestic portfolios and move that money to overseas markets.
There’s just one problem with that strategy…
Small Caps Everywhere Are Struggling
Were it just the iShares Russell 2000 Index ETF losing ground in comparison to its large cap counterparts like the SPDR S&P 500 ETF Trust, the decision to take on more international exposure might actually make sense. But it’s not just U.S. small caps taking on water. The Claymore/AlphaShares China Small Cap ETF (HAO) has fallen 8.5% since its March 5th peak, while the iShares FTSE/Xinhua China 25 Index ETF (FXI) is up nearly 3% since then.