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Is This Little-Watched Stock Market Niche Signaling a Crash Ahead?

By Dan Caplinger - Updated Mar 23, 2021 at 8:09PM

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You have to look beyond the Dow to notice something going on.

The stock market appeared to be on solid ground on Tuesday morning, with market participants carefully balancing their positive views about what a post-pandemic future will bring against the possibility for disappointment in the near term. As of 11:45 a.m. EDT, the Dow Jones Industrial Average (^DJI 2.68%) was down about 28 points to 32,703. The S&P 500 index (^GSPC 3.06%) inched higher by 3 points to 3,943, while the Nasdaq Composite (^IXIC 3.34%) gave up 20 points to 13,357.

Those small moves gave the impression that stock market investors are generally comfortable with the way things are going right now. But for the second day in a row, another often-neglected part of the stock market acted very differently. That could be a sign of difficulty ahead -- and might even presage a sharp and painful downturn in the near future.

Person in suit looking up at giant-sized lower legs wearing similar suit.

Image source: Getty Images.

Small-caps are feeling the pain

Many investors don't pay much attention to small-cap stocks , but they play a vital role in gauging the health of the economy. Many large-cap stocks have global scope, and their share prices therefore more often represent the health of the global economy. By contrast, smaller companies are more likely to focus on their home markets. That means U.S. small-cap stocks often have exposure only to the U.S. economy.

It's therefore troubling to see the Russell 2000 Index fall sharply over the past week. On Tuesday, the Russell was down 1.7% near midday. Looking back over the past week, even as the major large-cap indexes have stayed in a tight range, varying from being up slightly to down around 1%, the Russell has seen a big drop of nearly 6%. That's already a minor correction in many investors' eyes.

IWM Chart

IWM data by YCharts.

Small-cap companies face an uncertain environment that could go in either direction. On one hand, there's a huge amount of pent-up demand for companies in certain industries, and once the pandemic is under control, those businesses stand to see substantial rises in revenue and profits. However, small-cap stocks are also more sensitive to macroeconomic factors like interest rates. The rise in longer-term rates has been troubling for small companies, especially those that took on additional leverage during the pandemic in order to keep their operations afloat. Higher borrowing costs could divert capital away from growth efforts at exactly the worst possible time.

Some of the downward move also relates to the heavier concentration of energy stocks among small-caps. Large-cap indexes have very little energy exposure, but sizable drops in companies like Laredo Petroleum (LPI -2.90%) and Nabors Industries (NBR 10.98%) over the past week have had an impact on the Russell.

Reverting to the mean

The counterargument to worries about small-cap stocks is that when you look over even slightly longer time frames, they're still doing relatively well. So far in 2021, the Russell has gained almost 13%, which is more than double what investors in the Dow and S&P have seen. A slight pullback for the small-cap benchmark from its peak outperformance earlier this month certainly doesn't mean that a stock market crash is imminent. Short-term swings happen all the time.

Nevertheless, with comments from Treasury Secretary Janet Yellen and Fed chair Jerome Powell expected later Tuesday, Wall Street will still be watching the overall market and small-cap stocks in particular. If this disparity continues, it won't be a good signal for those hoping for a strong recovery in Main Street U.S. businesses in 2021.

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Stocks Mentioned

Laredo Petroleum, Inc. Stock Quote
Laredo Petroleum, Inc.
$72.12 (-2.90%) $-2.15
Dow Jones Industrial Average (Price Return) Stock Quote
Dow Jones Industrial Average (Price Return)
$31,500.68 (2.68%) $823.32
S&P 500 Index - Price Return (USD) Stock Quote
S&P 500 Index - Price Return (USD)
$3,911.74 (3.06%) $116.01
NASDAQ Composite Index (Price Return) Stock Quote
NASDAQ Composite Index (Price Return)
$11,607.62 (3.34%) $375.43
Nabors Industries Ltd. Stock Quote
Nabors Industries Ltd.
$134.28 (10.98%) $13.29

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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