At a time when the U.S. stock market is staying bullish, small-cap stocks are sending a yellow signal and indicating a potential economic recession ahead. Stock market bulls ought to pay attention.

Let’s explore with the help of a chart.

The chart

Please click here for a chart of the SPDR S&P 500 ETF SPY  (top pane), the Invesco QQQ Trust QQQ  (which tracks the Nasdaq-100 Index) in the bottom pane and the iShares Russell 2000 ETF small-cap ETF IWM  (middle pane).

Please note the following:

• A chart of the Dow Jones Industrial Average DJIA looks similar to the chart of the S&P 500 Index SPX represented by SPY.

• In the recent rally, small-caps have significantly underperformed.

• Since small-caps are mostly domestic and the market is concerned about the trade war, from one perspective, small-caps should have over-performed.

• Small-caps have also underperformed popular tech stocks such as Apple AAPL, Google holding company Alphabet GOOG,  GOOGL,  Facebook FB,  Intel INTC and Advanced Micro Devices AMD.  Popular tech stocks have problems ranging from the trade war to antitrust investigations.

• Small-caps often underperform going into a recession. The reason is that balance sheets of small-caps are often not strong and borrowing becomes difficult in a recession. Further, small-caps cannot cushion a domestic recession with overseas earnings.

Yellow signal — not red

At this time, small-cap underperformance is a yellow, not a red, signal for the stock market. The reason is that the small-cap index contains a large number of financials. Financials may get hurt by the inverted yield curve. Under some circumstances, an inverted yield curve itself is a signal of a pending recession; but no conclusions can be drawn at this time because of the extraordinary policies of the Federal Reserve…Read more at MarketWatch.

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