Small caps are now leading on the downside, and have broken their key trend line.
Investors should be wary of momentum and seasonal weakness as investors shed risk assets.
Other opportunities in large cap stocks, fixed income, and cash can help cushion volatility.
The direction of stocks has been decidedly mixed over the last several months. Large cap indexes such as the SPDR S&P 500 ETF (NYSEARCA:SPY) and Dow Jones Industrial Average ETF (NYSEARCA:DIA) have been mostly trading sideways, with some slight upward directional bias. The tug-of-war between earnings, economic data, and interest rates has helped to put a modest floor under larger, cash-rich companies.
However, the same can't be said for small cap stocks, which have been under more selling pressure recently. The iShares Russell 2000 ETF (NYSEARCA:IWM) broke below its 200-day average this week for the first time since November 2012, signaling a pause (and perhaps change) in trend for these growth-sensitive stocks.
On the surface, this may seem like a somewhat benign decline of 9% from the 2014 highs in IWM. However, there is some legitimate concern mounting that small cap stocks may become be a leading indicator of weakness that will spill over into the rest of the market. It would not be surprising to see this index lead a correction lower after being one of the strongest segments during this bull market.
Over the past two years, nearly every modest pullback in growth-oriented sectors has been bought with gusto. This has led to the price of small cap stocks severely outpacing earnings growth and pushing valuations to extreme levels. The concern more recently has been the inability of IWM to mount any convincing push higher when nearly every intra-day rally is met with heavy selling pressure.
In addition, we have seen dollars shifting from more aggressive areas like biotechnology, solar, and social media stocks to defensive names in utilities, consumer staples, and energy. All of these signs point to an unwinding of risk and a shift to value or dividend opportunities as a function of inter-market dynamics.
These same forces have been a tailwind for fixed income as well. Portfolio managers have been aggressively repositioning their asset allocation to account for a scenario where we see additional volatility in stocks and flight to safety in bonds. ETFs such as the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA:LQD) and iShares 7-10 Year Treasury ETF (NYSEARCA:IEF) have been trading sharply higher and gaining assets as a function of risk management.
From a seasonal standpoint, we're now exiting the strong growth months and entering a historically lackluster period. That means you should be extra vigilant about positioning your portfolio in the areas that represent the strongest chances for success. I don't believe it's time to clear the decks and run to cash, but you should be carefully monitoring your holdings and assessing your risk relative to other opportunities.
One of the best strategies this year has been to simply be cautious, with a healthy dose of low-volatility large cap stocks, fixed-income, and even cash on hand to take advantage of new opportunities. Two long-term core equity holdings in my clients' portfolios right now are the iShares MSCI USA Minimum Volatility ETF (NYSEARCA:USMV) and First Trust NASDAQ Technology Dividend ETF (NASDAQ:TDIV), which have both exhibited positive momentum year-to-date. Both ETFs focus on selecting stocks with dividend or value characteristics that make them attractive in this type of market.
I believe this theme will continue for the near future, and as such, you should be flexible with your asset allocation to control risks. Patience and discipline will be rewarded with additional tactical themes as a result of shifting trends that you can use to your advantage. Even volatile areas like small caps will once again present an attractive opportunity to capitalize on under the right circumstances.
Disclosure: I am long USMV, TDIV. 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.
Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.