Can Lagging Small Caps Play Catch-Up?

The Russell 2000 small-cap index has failed to join blue-chip benchmarks at new highs, despite favorable seasonality and a major uptick in speculative fervor. This unusually weak performance stands out like a sore thumb in the first quarter landscape, affecting market breadth readings that usually soar during bull market runs. Unfortunately, positive seasonal forces tend to wane between March and May, warning that small caps may be running out of time to play catch-up.

The January effect had a positive but limited impact on this corner of the market universe, with a week-long mid-month advance reversing about three points under major resistance at the 2018 bull market high. The index has bounced after a coronavirus-driven downdraft but still hasn't rallied back to last month's peak. More importantly, it's showing no inclination to finally cover the distance up to last year's high and break out.

Two positive macro forces have had little impact on Russell and its derivatives so far in 2020. First, the U.S. Dollar Index has lifted forcefully off 2018's three-year low and is trading relatively close to the 2016 high, which also marked a 14-year high. Domestically oriented small caps should outperform when the dollar strengthens because multinational corporations and other blue chips face currency headwinds. However, that hasn't happened, highlighting the historic but unsettling transition of Western capitalism into a handful of mega-companies.

Second, technical gurus tell us that a "rising market will float all boats." This expression is often used to explain why laggards gain ground during big rallies, despite weak earnings or a bearish outlook. However, small caps should also react to this long-observed tendency as traders take profit in over-priced winners and rotate capital into lower-risk opportunities. There's little evidence of this rotation so far, but it might be waiting until the current leadership tops out.

IWM Long-Term Chart (2000 – 2020)

The iShares Russell 2000 ETF (IWM) came public in the mid-$40s in the second quarter of 2000 and joined broad benchmarks in a bear market when the internet bubble burst. It posted an all-time low at $32.29 in October 2002 and turned higher, posting healthy gains during the mid-decade bull market. The uptrend topped out in the mid-$80s in the summer of 2007, giving way to a pullback that accelerated into a vertical rout during the 2008 economic collapse.

The fund found support just two points above the 2002 low in March 2009 and bounced into the new decade, stalling at the .786 Fibonacci sell-off retracement level in April 2010. It completed the round trip in the second quarter of 2011 but didn't break out until the start of 2013. Committed bulls took control at that time, lifting the fund to $115 in March 2014. A breakout above that level one year later failed, yielding a steep decline that found support at a three-year low in February 2016.

Another breakout after the 2016 election posted an all-time high at $173.39 in August 2018 and reversed in a fourth quarter swoon that ended at a two-year low on top of 2016 breakout support. The 2019 recovery wave stalled in February just above the .618 sell-off retracement level, marking resistance into a November breakout that has so far failed to reach the 2018 peak. However, the rally into January 2020 mounted the .786 retracement level, which often marks the final barrier ahead of a 100% retracement.

IWM Short-Term Outlook

The fund has been testing that harmonic level for the past three months but still hasn't confirmed new support. The monthly stochastic oscillator has lifted into the overbought zone at the same time and crossed over in a potentially bearish event that will generate a long-term sell signal if the blue line drops through the 80% level. It will only take a few days of selling pressure for that signal to take control, warning that the Russell 2000 may be running out of time to play catch-up.

The Bottom Line

The Russell 2000 small-cap index has underperformed blue-chip benchmarks so far in 2020, failing to capitalize on positive first quarter seasonality.

Disclosure: The author held no positions in the aforementioned securities or their derivatives at the time of publication.