Small cap stocks have done this with more volatility. The old saying of the greater the risk the greater the return applies here; corrections for small cap stock ETFs like IWM were more severe than for the SPY. The 20-trading day annualized volatility of the IWM is 24.6% and for the SPY it is 15% both as closing prices this Friday.

Looking at a weekly frequency chart of the IWM going back to 3/12/03, the IWM corrects with lower lows and lower highs for 3-4 months before bursting higher again (during the bull market phase). I think we are now at the end of a consolidation period for the IWM and we can look forward to larger gains for the IWM compared to the SPY if the general uptrend of the market continues through the spring of 2010—but this is only from a technical perspective.

Of course, large cap stocks were the place to be from 1995 to 2000—but that was a period of a strengthening $US. So the question is: what do the economic fundamentals say about the relative merits of small caps versus large caps for the near term and the intermediate term? There are too many economic and financial crosscurrents at work now which are beyond me to sort out. Therefore, I’m diversifying with some high yielding small/mid/large cap stocks and small/mid cap stock ETFs, call options on sold off Jubak’s picks with a dollop of foreign stocks and finally lots of TIPs (instead of money market mutual funds).

The S&P 500 (as represented by SPY) is hitting resistance around $112, it still remains near its 2009 high. Price always pays and should take precedent. However, two of the most widely followed indicators, RSI and MACD, have shown negative divergence since August. While investors have hesitated to sell large cap stocks at current levels, price activity of “riskier” small caps tell a different story.

The Russell 2000 (as represented by IWM) has drifted lower since a double top around $62.50 in September and October. For bulls, they would consider the current move a consolidation and bears may see it as the beginning of further downward moves. However, today’s close below the 50 day moving average indicates an intermediate bearish trend and IWM has had difficulty sustaining itself above the 50 day SMA since October. The long term trend is still positive as long as IWM remains above the 200 day moving average. $62.50 is a price level to watch on the upside and the November low of $55.33 would be a price level to watch for further downside confirmation. IWM showed negative divergences in October and subsequently began to move lower. Will SPY follow suit?