Small-Cap ETFs Signal Big Warning Signs Now

NEW YORK (Fabian Capital Management) -- The direction of stocks has been decidedly mixed over the last several months. Large-cap indexes such as the SPDR S&P 500 ETF (SPY) and Dow Jones Industrial Average ETF (DIA) have been mostly trading sideways with some slight upward directional bias. The tug of war involving earnings, economic data and interest rates has helped to put a modest floor under larger, cash-rich companies.

However, the same can't be said for small-cap stocks, which have been under more selling pressure recently. The iShares Russell 2000 ETF (IWM) broke below its 200-day average this week for the first time since November 2012, signaling a pause (and perhaps change) in trend for these growth-sensitive stocks.

On the surface, this may seem like a somewhat benign decline of 9% from the 2014 highs in IWM. However, there is some legitimate concern mounting that small-cap stocks may become be a leading indicator of weakness that will spill over into the rest of the market. It would not be surprising to see this index lead a correction lower after being one of the strongest segments during this bull market.

Over the past two years, nearly every modest pullback in growth-oriented sectors has been bought with gusto. This has led to the price of small-cap stocks severely outpacing earnings growth and pushing valuations to extreme levels. The concern more recently has been the inability of IWM to mount any convincing push higher when nearly every intraday rally is met with heavy selling pressure.

In addition, we have seen dollars shifting from more aggressive areas like biotechnology, solar, and social media stocks to defensive names in utilities, consumer staples, and energy. All of these signs point to an unwinding of risk and shift to value or dividend opportunities as a function of inter-market dynamics.

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