Should You Own Small Cap ETFs? [iShares Russell 2000 Index (ETF), iShares S&P SmallCap 600 Index (ETF)]

new etfsDavid Fabian:  Small cap stocks were one of the strongest areas of the market in the first half of the year and have recently seen much of their gain for the year erased. Growth investors are typically emboldened by periods of strength in smaller companies because they have traditionally been leaders during bull markets.

Nevertheless, the recent weakness is a concern and should be noted as significant divergences are popping up throughout the broader market.

Let’s examine where we stand today and some potential scenarios that could develop….

The initial leadership in the benchmark iShares Russell 2000 ETF (NYSEARCA:IWM) was driven by strength in technology, health care, and consumer discretionary stocks. IWM led the large-cap oriented SPDR S&P 500 ETF (NYSEARCA:SPY) by 3.5% through the first six months of 2015, yet has surrendered those gains after a size-able drop in July and August.

iwm_spy

IWM has recently breached its 200-day moving average on the downside and managed to claw back a portion of that drop. It is now seated firmly near this long-term trend line and appears to be setting up for another big move.

As you can see on the chart below, the succession of lower lows and lower highs has created a stair step pattern in IWM. Technical analysts would consider this to be a bearish sign that favors lower prices. Nevertheless, if IWM can move back to the green for August and recapture its 50-day moving average on the upside, much of this damage can be repaired.

IWM

The catalysts for this type of move will likely depend heavily on the breadth and sentiment throughout the broader stock market. The summer is historically a very volatile period of time for stocks that can lead to repositioning and a pullback in overall risk taking. That coincides with the type of drop that we have already experienced in the small cap segment versus the relative lack of movement in large-cap stocks.

If the bulls can pull it together and mount another rally attempt, the momentum may ultimately shift back to small cap indexes that have farther to run to recapture their highs.

Selecting Your Small Cap Exposure

While IWM may be the largest and most well-known small cap index, I actually favor the iShares Core S&P Small Cap ETF (NYSEARCA:IJR) or Vanguard Small Cap ETF (NYSEARCA:VB) as core holdings.

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