The Hunt For Red October: Small-Caps Are Blowing The Whistle Real Hard

by: The Fortune Teller


The devil is in the details and what you see on the surface (index) isn't what you see underneath (specific sectors/stocks).

Small-caps are known to be a trusted whistle-blower when it comes to the broad market.

If so, we may a trouble. A double-digit decline kind of trouble.

(This article has been written/submitted on October 10th, before market open)

The Hunt For Red October

Red October

It was all great until October, with the average stock in the S&P 1500 (ITOT, VLU) was up 9.24% YTD through September.

Source: Bespoke Investment Group

Then came October...

To some extent, one can't say this was unexpected. Historically, as the below chart shows, small-caps tend to lag large-caps during the 4th quarter.

However, no one has expected such a major drop and lagging as we are seeing over the past 10 days.

Small Caps (Overall)

Small-cap stocks (that are part of Russell 2000 index) are about to rap a disastrous 6-week period, during which the iShares Russell 2000 ETF (IWM) fell from as high as 173.39 on August 31st, 2018 to as low as ~156 on October 9. That's a decline of 10% over the course of only 27 trading days!

Chart IWM data by YCharts

The relative weakness of small-caps (IWM) versus large-caps (SPY) is notable and actually been ongoing since the beginning of the third quarter this year.

Trading at their lowest level since May this year, small-caps are in danger of closing below the 200-day moving average for the first time since August 2017.

However, within the small-caps arena we have two main sub-segments: growth and income - and the former already "succeeded" doing what the overall segment hasn't done so as of yet.

Growth Small Caps

Small Cap growth stocks (IWO) have not closed below their 200-day moving average for more than two years, until yesterday... This record run, which started a bit before the US elections in November 2016, is now over.

Lagging, Big Time

Per Bespoke Investment Group:

1. Stocks in the S&P 600 Small Cap index are down, on average, over 20% (including yesterday's action) from their respective highs.

Source: Bespoke Investment Group

2. Stocks within certain sectors that are trading the most off their respective highs (including yesterday's action):

  • Small-cap Technology (XLK), Consumer Discretionary (XLY), and Health Care (XLV) stocks are down, on average, between 25% to 30% off their respective highs.
  • Large-cap Consumer Discretionary and Materials (XLB) sector are trading down down, on average, about 20% off their respective highs.

Source: Bespoke Investment Group

3. Stocks within certain sectors that are trading the closest to their respective highs (including yesterday's action):

  • Small-caps in the Utilities (XLU) sector are down less than 5% on average from their 52-week highs.
  • Large-caps in Utilities, Energy (XLE) , and Real Estate (XLRE, IYR, VNQ) are the only three sectors where stocks are down less than 10%, on average, from their 52-week highs.

Source: Bespoke Investment Group

What's Next?

We're watching the Russell 2000 closely, as it's diverging from the S&P 500. Taking into consideration that small-caps are known to be a reliable whistle-blower for the entire market, this divergence might be suggesting (that more) trouble (might be) ahead for the broader market.

Over the long run, small-caps typically move in tandem with large-caps but that hasn't been the case for 3.5-month already.

Since June 20th, small-caps have fallen over 8% while the S&P is actually still up about half a percent. That's an over-8.5% under-performance for small-caps!

Chart IWM data by YCharts

Looking back at similar divergences along history, one can't help but be reminded of 2015, when the Russell 2000 topped out two months before the S&P 500 did the same. As a friendly reminder, let me refresh your mind with what came right after - a 14% decline for the S&P 500.

Just saying... not whistle-blowing!

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Disclosure: I am/we are long XLU, XLP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I'm/we're short SPY & QQQ