Small Cap Stocks – A Warning Signal For The Market

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

The above chart shows in the upper panel the ratio of IWM and XLP. The business cycle indicator is shown in the lower panel. The cyclicality of IWM is now clearer and suggests an attractive investment strategy.

The chart shows IWM outperforms XLP when the business cycle rises. It underperforms XLP, however, when the business cycle declines. 

Particularly noticeable is the sharp decline of the ratio of IWM and XLP since late February. The pattern is quite similar to the other spikes that took place in 2011, 2014, and 2018. It is important to recognize the business cycle reached a peak and started to decline in those years. This decline warned investors they had to switch their strategy from cyclical stocks to defensive stocks and bonds.

Similar conclusions could have been reached by comparing IWM to TLT (iShares 20+ Year Treasury Bond ETF).

Key takeaways

IWM has the tendency to appreciate rapidly when the business cycle rises. It weakens when the business cycle declines, signaling slower economic growth.

IWM outperforms the market (SPY) when the business cycle rises. It underperforms the market when the business cycle declines.

IWM outperforms XLP (or TLT) when the business cycle rises. It underperforms XLP (or TLT) when the business cycle declines.

The current weak performance of IWM suggests the economy is likely to slow down.

The action of IWM compared to SPY and XLP (and/or TLT) suggests a procyclical investment strategy. Invest aggressively in IWM when the economy strengthens (the business cycle is in Phase 1 & 2). Sell IWM and invest in XLP (and/or TLT) when the business cycle declines (the business cycle is in Phase 3 & 4). 

Summary

Small cap stocks are great performers, some of the time.

They appreciate the most when the economy strengthens.

They give a reliable buy/sell signal when compared to staples.

 

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

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