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Should you worry about the S&P 500 and Russell 2000 divergence?

Mike Kane of Hedgeable

Must-read: It’s not easy being small (caps, that is) (Part 0 of 1)

Divergences between the S&P 500 (IVV) and the Russell 2000 (IWM) have been poor indicators for the overall market, historically. According to a recent report from Sundial Capital Research, when the S&P hits a 52-week high while the Russell 2000 is more than 5% below its own 52-week high, the S&P declines by an average of 2.1% in the following month. Small-cap swoons like the one happening now usually occur when investors look to cut down risk and move into more defensive sectors.

Market Realist – The graph above compares the prices of the S&P 500 (SPY) and Russell 2000 (IWM) indices. As you can see from the graph, the S&P 500 has been steadily climbing this year, while the Russell 2000 has been declining so far. The divergence between the two indices is clear from March 2014.

 As tensions in the mid-east boil over and uncertainty in Crimea is intensified, it is important to keep an eye on the risks now present in the markets, exemplified by the abnormal spread between large (SPY) and small-caps (IJR). It just might be indicative of a market downturn in the near future.

Market Realist – It could be a good idea to diversify with energy equities (XLE), emerging markets (EEM), and large cap developed market stocks to protect against rising geopolitical risk, as they have done well this year in the turbulent geopolitical setup.

To find out more about safe-haven assets, read our series  Overview: Safe-haven assets.