Take Note, Investors: 4 ETFs That Signal Trouble Ahead

Source: Thinkstock

Source: Thinkstock

As the S&P 500 hits a new all time high and nears the 2,000 level, investors are naturally bullish. But I think the next couple of months will prove to be an excellent time for investors to take profits, as the Fed plans on ending its quantitative easing program. Each time it has done so in the past, we have seen steep and swift corrections in the stock market that have led the Fed to come back into the bond market with additional stimulus.

There is no reason to believe that this time is different, and I think that the smart money is preparing for a correction. We can see this by looking under the hood at individual sectors and groups of stocks that can tell us a lot more than just the S&P 500. While there are almost certainly more, I have selected four groups represented by ETFs that I think investors need to look at in order to better grasp what is going on in the market and in the economy.

1. The iShares Russell 2000 ETF (NYSEARCA:IWM)

While large caps have had a strong year, small caps have not, and this is evidenced by the weak performance of the Russell 2000, which is flat for the year. Furthermore, it made a double top in March and early July, suggesting that investors are selling their small cap holdings on strength. Small caps tend to outperform when investors are more optimistic, and they underperform when investors are more risk averse. This is the case because small companies, on the one hand, have more room to grow, and they are nimbler, but on the other hand their sales and profits are more volatile, and they don’t have as much access to capital. Thus, the underperformance of the Russell 2000 is a bad omen, and if the Russell 2000 continues to underperform I would be less willing to hold stocks more generally.

Source: Thinkstock

Source: Thinkstock

2. The SPDR Energy ETF (NYSEARCA:XLE)

Energy is now the best performing sector of the year as utilities have begun to correct. Oil and gas prices are rising, and as a result energy companies are better positioned to make money. Rising energy prices could be signaling that energy is in greater demand, and this would mean that the economy is improving. But we know that there is political tension in the Middle East, which supplies about a third of the world’s oil, and in Eastern Europe, Russia supplies about 10 percent of the world’s oil. So while energy prices are rising and energy companies are benefitting, everybody else suffers because they need to buy energy at a higher price.

Source: Thinkstock

Source: Thinkstock

3. The SPDR Utility ETF (NYSEARCA:XLU)

This fund has cooled off as of late, but utilities are still the second best performing sector in the S&P 500 year-to-date. Investors typically buy utilities because they want stability and because they want dividends. Thus, their outperformance signals that investors are risk averse because they are less willing to own growth stocks that trade at high valuations and pay no dividends. Note that utilities have started to underperform, although this is a short-term trend, and we have seen underperformance from other sectors such as small-caps and, as we will see in a minute, retailers. Thus, the recent correction in utilities is probably only a short-term correction, and I think the rotation into safer assets such as utilities will continue.

Source: Thinkstock

Source: Thinkstock

4. The SPDR Retail ETF (NYSEARCA:XRT)

This fund has been one of the worst performing sector ETFs in the S&P 500. It is actually down 4 percent, and it has underperformed the S&P 500 by 11 percent. That’s a big deal. Further, while the fund tried to break out of its downtrend in April, May and June it fell sharply after hitting resistance, suggesting that investors are selling strength. Retailers are highly sensitive to economic activity, and even a small rise or fall in sales can have a huge impact on its bottom lines. With this being the case, the weakness that we have seen in the space suggests that consumer spending isn’t very strong, and by extension, the economy isn’t as strong as some economists would have you believe. If the retail space continues to underperform, it could signal further weakness in consumer spending and a potential recession.

Disclosure: Ben Kramer-Miller has no position in the funds mentioned in this article.

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