The underperformance of small caps has made headlines in recent months, but now the situation might be about to take a more serious turn.
A look at the flagship small-cap ETF — iShares Russell 2000 ETF (IWM) — shows a chart that could be on the verge of accelerating to the downside unless it can gain some traction in relatively short order.
A number of potential issues stand out:
First, IWM closed below its 50-day moving average on Tuesday, and it sits just a few cents above its 200-day moving average. What’s more, the ETF only needs one more day in the red to form a “death cross,” or a move in the 50-day moving average below the 200. The last time the 50-day MA stood below the 200 was all the way back in February 2012, while the last death cross occurred in August 2011.
IWM one-year chart
These events are sure to get a lot of attention, but it remains to be seen what they’re really telling us. Small-caps broke through their 50- and 200-day moving averages in mid-May, but proceeded to rally more than 10% in the next month and a half. Another break happened in July, but that too was followed by a meaningful rebound.
Death crosses in the Russell 2000 Index often can turn out to be head-fakes as well. While the signal was effective in late 2007, it also gave false indications on multiple occasions — most recently 2006, 2007, and 2011.
IWM 10-year chart
This indicates that IWM’s action around its moving averages can often send mixed signals.
Still, there’s more to the story right now.
The IWM ETF has also made a series of lower closing highs and has established a broad, rounding top. IWM’s current triangle formation shows defined support in the $107.20-$107.50 range, which corresponds to 1080 on the Russell 2000. That still leaves room for the index to fall another 5%-plus without experiencing a more serious, longer-term breakdown.
Nevertheless, given small caps’ recent weakness, this is a formation that bears close watching. A break below this level would put the IWM ETF near a 52-week low, and it would serve as a major warning sign for the rest of the market.
Further, small-cap stocks tend to have a strong correlation with high-yield bonds over time. While that has been a distinct positive in recent years, it’s noteworthy that high yield — as shown in the accompanying chart of iShares High Yield Corporate Bond ETF (HYG) — has given back almost all of the gains from the relief rally that it experienced in August. This weak price action represents yet another potential canary for small caps.
HYG one-year chart
Strong Earnings, But High Valuations
From a fundamental standpoint, U.S. small caps still have an important tailwind that argues against putting too much stock in the technical picture: They’re a source of growth at a time of general economic malaise across the globe.
According to S&P Capital IQ, stocks in the small-cap S&P 600 Index are on track for 21.5% EPS growth in 2014, vs. 7.9% for the S&P 500. In 2015, current estimates are calling for 30.7% growth for small companies vs. 11.9% for large caps.
That’s all well and good, but investors also are paying through the nose. Even after small caps’ year-to-date underperformance — -0.2% for IWM versus 9.6% for the SPDR S&P 500 ETF (SPY) — the asset class still commands a valuation premium well above historical norms. Based on this chart from the Leuthold Group, small caps’ current premium of about 20% is well above the long-term median of 2% and close to the all-time high established in early 2012.
Not only that, but investors are giving up a little over a half of a percent worth of yield to invest in small caps. While IWM offers an SEC yield of 1.24%, SPY pays 1.8%. That’s not a huge difference in any given year, but it makes smaller companies relatively less attractive at a time in which investors continue to demonstrate a hunger for yield.
The Bottom Line
Put it all together, and small-cap stocks are in a difficult position by almost any measure. With just a little bit more downside, key indicators will begin to paint a more bearish picture.
The key takeaway? Keep a close eye on the charts. If IWM experiences a sustained break below its moving averages and begins to head toward support at $107.50, it’s a sign that small caps could be in for even rougher performance in the months ahead.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.
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