September 2008 Small-Cap Signal Just Flashed Again

What it means when small-cap and large-cap stocks diverge

May 29, 2018 at 9:00 AM
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Small-cap strength has been a major storyline lately -- and a much-needed morale boost for bulls in an otherwise choppy, range-bound market. While the S&P 500 Index (SPX) and its exchange-traded fund (ETF) counterpart, the SPDR S&P 500 ETF Trust (SPY), have been fighting headwinds since their January all-time highs, the Russell 2000 Index (RUT) and its companion ETF, the iShares Russell 2000 ETF (IWM), once again last week one-upped their larger-cap counterparts by breaking out to new record highs (and during a month most famous among investors for being a good time to "sell and go away," no less).

The new IWM intraday record set last Tuesday, May 22, checked in at $163.33. And during the same session, SPY traded as low as $272.24 -- a full 5% below its own Jan. 26 record intraday high of $286.63. This echoed a similar disparity that signaled the week prior, on May 16; IWM tagged a then-record best of $161.32 on an intraday basis, but SPY went on to close the day at $272.24, squarely at the same "5% below its high" price point that marked its session low this past Tuesday.

Conventional wisdom tells us that small-cap leadership is generally a welcome sign for stocks, but the nature of this latest instance -- fresh IWM highs repeatedly occurring in concert with mirror-image SPY lows 5% below its own high -- led us to examine whether there was any historical precedent for this kind of divergence, and what the ramifications might be going forward.

Starting with that May 16 signal, Schaeffer's Senior Quantitative Analyst Rocky White reports there have been just two prior instances where SPY has closed 5% off its 52-week high the same day that IWM set a new annual high, and the results after these signals have been uniformly grim. Those two dates (April 16, 2002 and Sept. 19, 2008) are marked with red dots on the accompanying chart -- and while the visuals largely speak for themselves, there are some details worth calling out.

First, both SPY and IWM traded lower across the board following each of these signals, looking at returns over the ensuing one-week, one-month, three-month, and six-month periods. Losses were heaviest after the September 2008 signal, which occurred amid the financial crisis. SPY was off 28% at the three-month mark and 33.8% at six months, while IWM lost 35.4% and 42.2%, respectively, over the same time frames. Black swans aside, though, the 2002 post-signal returns were also bleak. SPY was down 20% three months after the signal, and 25.2% lower after six months -- just barely outperforming IWM's comparable losses of 22.3% and 33.7%.

Turning to the IWM/SPY disparity we witnessed just last Tuesday, SPY did manage to close the day at $272.61, at which point the decline off its intraday record had narrowed to 4.9%. When White adjusts the parameters of his study to account for instances where SPY closes 2% or more off its high simultaneous with a new IWM intraday high, the outlook isn't terribly rosy -- but it's generally less catastrophic than the smaller sample discussed above. There have been 10 previous instances (including one on May 14), and both SPY and IWM underperform their comparable "anytime" returns over the following one-week, one-month, three-month, and six-month periods. At the six-month mark, SPY is down 3.3%, on average (compared to a gain of 3.6% on an "anytime" basis), while IWM averages a 5.1% drop at the six-month mark (compared to an "anytime" 4.8% gain).

This analysis is not intended to "dispel the myth" of small-cap leadership being a positive for the stock market -- because it's not clear that the recent RUT/IWM highs are an example of "leadership," per se, so much as "divergence." And based on the SPY and IWM returns following previous such divergences, we'd suggest this particular brand of small-cap divergence is one that warrants the cautious attention of investors.

stocks after iwm leads to new highs

Subscribers to Bernie Schaeffer's Chart of the Week received this commentary on Sunday, May 27.


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