Small-Cap ETFs Signaling A Pullback?

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 |  Includes: DIA, IWM, SPY
by: Tom Lydon

By John Spence & Tom Lydon

The stock correction that seemingly everyone has been waiting for since late 2012 has failed to materialize as the Dow Jones Industrial Average simply continues to grind higher. However, U.S. small-cap stocks were noticeably weaker than the Dow on Monday and will give investors a warning signal if this trend continues.

The iShares Russell 2000 (NYSEARCA:IWM) dropped 1% on the first day of the new quarter but the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) was slightly in the green at last check.

The divergence caught the attention of technical analysts who watch the performance of small-cap ETFs as a gauge for risk appetite in markets, partly because they are more volatile. When small caps are leading the market it's often a sign that investors are willing to take on more risk in their portfolios.

"Small-cap stocks tend to be more volatile due to narrower economic moats and a greater sensitivity to macroeconomic risks," says Morningstar analyst Michael Rawson in a report on IWM, the small-cap ETF.

IWM posted a total return of 12.3% in the first quarter to outperform SPDR S&P 500 (NYSEARCA:SPY), which gained 10.5%.

The chart below shows the relative performance of IWM versus SPY and the leadership of U.S. small-cap stocks since mid-November. Investors should keep an eye out for a potential reversal of the trend.

Click to enlarge

Full disclosure: Tom Lydon's clients own SPY and IWM.

Disclosure: I am long SPY, IWM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.