Don’t Let Weakness in Small Caps Send You Overseas

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:

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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.

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Don’t look for any relief in Europe either…


Since its March 5th peak, the iShares MSCI United Kingdom Small Cap ETF (EWUS) has lost nearly 8% of its value. The iShares MSCI United Kingdom Index ETF (EWU), however, has managed to dole out a gain of 3.1% for the same time frame.

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As one might imagine, most of the rest of the world’s small caps have also been underperformers, largely for the same reason the Russell 2000 has been notably weaker than the S&P 500. That is, investors everywhere are fearing the end of the bull market in their respective home-market, and they’re defensively dumping their small caps.

Whether all these investors are right may be irrelevant. If they believe they’re right and trade accordingly, they’ll jump-start the very bear market they’re so worried about now. Ergo, owning more international equities won’t offer any particular protection for domestic investors.

Bottom Line

Of course, the entire discussion may be moot if it turns out the weakness from the Russell 2000 or IYM is nothing more than just a little volatility.

Well, as it turns out, it may just be a little volatility.

For the record, since the March 2009 bottom, IWM has lost more than 10% a couple of different times. Neither of those instances kick-started a bear market. It’s also worth recognizing that since the March 2009 bottom, small caps had at one point gained as much as 240%, and may have been due for an outsized pullback. Conversely, the SPDR S&P 500 ETF Trust has only gained 174% for the same timeframe, reaching that peak level just this week.

Point being, it may simply be “one of those things” that doesn’t end up being anything.

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But what about the incessant chatter of red flags, warning signs, and the media’s seeming certainty of doom stemming from the demise of small caps? Anything’s possible, but that doesn’t mean everything is probable.

To give full credit where it’s due, Independent Adviser for Vanguard Investors’ Jeffrey DeMaso crunched the numbers. What he found was that since 1990, the biggest average pullback for small caps was 19%.

The current lull may feel a little more troubling simply because we haven’t seen a dip anywhere near that large 2011.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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