Small Cap Stocks – A Warning Signal For The Market

Eventually the decline in costs (lower commodities, wages, and interest rates) restores profitability. Consumers’ power increases and interest rates and inflation decline. The effect is increase in demand, forcing business to increase production to replenish depleted inventories. And Phase 1 is underway again.

The purpose of the following charts is to show the typical price action of small cap stocks during the phases of the business cycle, especially as it relates to IWM performance compared to the S&P 500 (SPY). 

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows the IWM graph in the upper panel from 2006 to 2021 with its 200-day moving average. The lower panel shows the business cycle indicator. 

IWM follows closely the pattern of the business cycle indicator. It appreciates rapidly when the business cycle rises, reflecting a stronger economy. IWM, however, pauses when the business cycle declines as the economy slows down. 

IWM has been rising sharply since March 2020. It has traded in a range, however, since early February. Because of its past relationship with the business cycle, it may be interpreted as a sign the economy is on the verge of a slowdown.

Source: StockCharts.com, The Peter Dag Portfolio Strategy and Management

The above chart shows the ratio of IWM and SPY. The ratio rises when IWM appreciates faster than SPY. The ratio declines when IWM underperforms SPY. 

The performance pattern of IWM compared to SPY follows closely the business cycle indicator. The relation between the graphs in the upper and lower panels suggests IWM outperforms the broad market (SPY) when the business cycle rises, reflecting a stronger economy. On the other hand, IWM underperforms the market when the business cycle declines as the economy slows down.

A clearer recurring pattern of IWM is evident when it is compared to consumer staples stocks. This correlation is even more striking and useful from an investment viewpoint when IWM is compared to consumer staples stocks (XLP).

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Disclosure: Check out The Peter Dag Portfolio Strategy and Management on www.peterdag.com. An ...

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