April has been rough for investors so far. And that’s putting it mildly. According to data compiled by Bloomberg, U.S. stocks just had their worst April start since 1929!

On the first day of trading for April (and the official start of the second quarter), the 2.2 percent drop in the S&P 500 was the worst since the Great Depression.

Market psychology has shifted from greed to complacency to worry in recent months. And now there is more than a whiff of fear. There was the fallout hitting technology stocks with a big data scandal rocking Facebook. And now there are worries of a trade war.

Wall Street analysts, and investors, seem divided. Should the US-China trade war threat be taken seriously? Some argue it should absolutely be taken seriously. Others think it is just another “wall of worry” that markets will successfully climb if earnings come in strong again.

The vast majority of economists (with a handful of exceptions) tend to fear trade wars. That is because an escalating trade war is like a game of chicken. Two or more countries make threats. Neither side backs down. “Tit for tat” makes the threats grow more serious.

The situation is like two cars driving straight at each other. The idea is to make the other car swerve first. If nobody swerves, the cars crash.

Right now, the rhetoric is very hot. The United States is going after China and Europe simultaneously. “If you look at the European Union, it’s very solidly against us in terms of trade,” said the president at a West Virginia rally. “It’s almost, we can’t even do business.” Whether that is accurate or wildly inaccurate, those are fighting words.

On Thursday, the US escalated things on the China side with another $100 billion of threatened tariffs. China’s response: Bring it on. “China doesn’t want a trade war, but we’re not afraid to fight a trade war,” said Lu Kang, a China foreign ministry spokesperson. “We will accompany [the USA] until the end, we will not hesitate in paying any price.”

Some analysts and investors argue this is going to blow over… that “cooler heads will prevail” as they usually do, because the stakes are too high otherwise.

A full-blown trade war would be economically damaging on all sides, and possibly devastating to vulnerable regions of the United States (including many areas of the heartland, and industries like soybean farming and small manufacturing). China and Europe would also feel a lot of pain. So much pain, the optimists argue, that surely this heated rhetoric will fade and things will calm down.

But what does the market think? How is the market gauging the prospects of a trade war specifically?

We can gain some insight into this by looking at how the different segments of the markets are doing. In particular, we can look at the relative performance of the S&P 500 and the Russell 2000 Index.

Why the S&P 500 vs. The Russell 2000?

Because the S&P 500 contains large, multinational companies – many of whom get a large percentage of revenue and profits from overseas – whereas the Russell 2000 is a small cap index, which contains mostly domestic companies that make money closer to home.

For decades, the companies in the S&P 500 index have generated roughly 40 to 50% of their revenues and profits from international sales. That makes these companies more vulnerable to trade war outcomes, as tariffs and restrictions hurt sales by making their goods more costly.

Companies in the Russell 2000 index, in contrast, have an international sales footprint less than half that size. This is because smaller companies export less on average and do more of their business locally.

So, we can look at the performance difference between the S&P 500 and the Russell 2000 index to get a sense of what the market is thinking. And right now, that performance difference is favoring the Russell 2000 and thus domestic small caps.

The simplest way for us to see this is to look at the TradeStops Stock State Indicator (SSI) status on these two indices. The S&P 500 has been in the Red Zone for nearly a month now while the Russell 2000 is still solidly in the Green Zone.

Stock State Indicators (SSI) for Russell 2000 and S&P 500


Where an index stands relative to its 200-day simple moving average is another popular way of evaluating the strength of an index. The farther above the 200-day moving average, the better the performance. Here are some recent numbers for both the S&P 500 and the Russell 2000 Index:

S&P 500 percentage distance above 200-day moving average: 1.53%

Russell 2000 percentage distance above 200-day moving average: 2.48%

That may look like a small discrepancy. But it is a notable relative performance gap. What makes it even more notable is the fact that normally during times when volatility and fear are on the rise, it is usually the case that large caps do better than small caps because large-cap companies are generally perceived as safer and more stable.

So, given the fact we have seen the worst quarterly start since the Great Depression… and a big rise in volatility that started in February… one would normally expect large caps to be doing better than small caps at this point. With worry on the rise, one would expect the large caps of the S&P 500 to be a relative outperformer to the Russell’s small caps.

But again, that isn’t the case. The opposite is happening. Small caps are significantly outperforming large caps on a relative basis, even in a market where volatility is on the upswing. Why is this happening?

The most logical reason is because large caps have far more exposure to international sales than the more domestically oriented small caps, which means large caps face greater danger from trade war fallout that could hurt profits and dim future outlooks.

In other words, the market is telling us to take the trade war threat seriously, and that’s yet another caution sign amidst a sea of concern.

You know that I love staying in my winners… but I’m happy to be building up some cash as I get stopped out of positions when the markets look this uncertain.

Have a great weekend,

Richard_Signature

Richard Smith, PhD
CEO & Founder, TradeStops