Small-Cap Bulls Shouldn't Panic Yet

The IWM's "death cross" isn't as ominous as it sounds

Oct 8, 2019 at 1:40 PM
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The U.S. small-cap focused iShares Russell 2000 ETF (NYSEARCA:IWM) recently made a "death cross" -- typically defined as its 50-day moving average moving south of its 200-day trendline. The last time this happened, nearly one year ago, spelled bad news for stocks in the short term. Here's what that ominous-sounding technical indicator could mean for small-cap stocks over the next year.

IWM death cross

IWM bulls can take solace in knowing that death crosses haven't been nearly as foreboding as their "golden cross" counterparts (when the 200-day moves back below the 50-day moving average). Three months after a death cross, the IWM was up 3.66%, on average, compared to 0.85% after a golden cross, per data from Schaeffer's Senior Quantitative Analyst Rocky White. That also exceeds the exchange-traded fund's (ETF) average anytime three-month gain of less than 2%. In addition, the fund was higher after a death cross 83.3% of the time.

Likewise, six and 12 months after death crosses, the IWM's returns handily exceeded both those after a golden cross and at anytime. In fact, a year after death crosses, the IWM averaged a healthy gain of 10.9%, and was higher 81.8% of the time.

IWM death vs golden crosses

Meanwhile, last week's death cross occurred with the IWM down roughly 3% vs. the broader SPDR S&P 500 ETF Trust (NYSEARCA:SPY) over the previous three months. Likewise, the last time the IWM made a death cross, nearly one year ago, it had also underperformed SPY -- by 6.32%, to be exact. In fact, looking at death crosses since 2000, there's been only one occurrence when the IWM had outperformed the SPY prior -- back in October 2008, at the height of the financial crisis.

IWM death crosses since 2000

Digging deeper, the tables below compare IWM returns based on how the exchange-traded fund performed vs. the SPY in the prior three months. The weaker the small-cap barometer performed vs. the SPY leading up to a death cross, the stronger it tended to bounce back.

When the IWM underperformed the SPY between 2.5% and 4% three months before a cross -- what we'll call a signal -- as it did on Oct. 4, it averaged a three-month gain of just 1.35%. That's compared to average gains of 2.41% and 7.21%, respectively, when the underperformance was below 2.5% or above 4%.

Six months after a signal, the IWM was up 4.88%, on average, but higher just half the time. That's compared to an average gain of 12.06% when the underperformance vs. the SPY was even more prominent, but still better than the ETF's average anytime six-month return of 3.99%.

However, a month after signals, the IWM was still in the red, but only lost another 0.89%, on average, and was higher half the time. That's compared to win rates of just 25% for the other two groups. Likewise, a year after signals, the IWM was up 14.76%, on average -- outperforming the other two groups, and much higher than the ETF's average anytime one-year return of 8.19%.

IWM death crosses based on SPY

In conclusion, history suggests small-cap bulls shouldn't panic over last week's death cross, or the sector's recent underperformance. In the short term, at least, stocks' trajectory is more likely to be determined by macro events, including U.S.-China trade talks later this week.

Further, as Schaeffer's Senior V.P. of Research Todd Salamone noted recently, traders should expect more "messy action" in equity benchmarks, as a "plethora of uncertainties has been thrown at market participants, ranging from how the Fed will deal with slowing world growth and China-U.S. trade tensions, to the instability in Hong Kong and the Middle East, a potential presidential impeachment, Brexit, and others."


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