Until last week, small-cap stocks’ underperformance was a frequently cited reason for bearish equity market forecasts. In fact, investor sentiment was so bearish (this chart shows it) that I said the following in the Sept. 4 Profit Radar Report:

“Range racing continues. The longer it lasts, the more people know about it, and the more people know about it, the higher the odds of a false breakout. In fact, a fake-out breakout would burn a lot of premature bears and may be just what is needed to clear the air for another leg lower.”

Zero to hero

Last month’s zero morphed into this week’s hero. The Russell 2000 RUT, +0.49%  popped 8.8% after sitting at a six-month low just a couple weeks ago. No doubt, this rally burned a lot of bears, and it may continue to do so. How come?

From Sept. 9-11, the Russell 2000 recorded three consecutive daily gains of more than 1% each, a rare feat.

Coming shortly after a six-month low, this has only happened eight other times in the 21st century. Seven of eight times the index was higher a year later, by 17% on average.

The green arrows in the chart, below, highlight the last four times this happened: January 2019, February 2016, October 2014 and October 2011.

Aside from the October 2014 low, this reads like a who’s who of market bottoms.

The February 2016 instance was also matched by the S&P 500 Index SPX, +0.01%, and prompted me to make this bold (and highly ridiculed) forecast: “Historical pattern says the risk of a 2016 bear market is zero.”

This “breadth thrust” track record speaks for itself. Nevertheless, I’ve learned to examine the merit of each signal. Here are two key questions:

1. Is it time to buy small-cap stocks?

2. Will small-caps buoy other indexes including the S&P 500, Dow Jones DJIA, +0.16%  and Nasdaq COMP, -0.16% ?

Let’s break down those questions.

For question No. 1: Yes for the long term. Still, a lower entry price is possible in the short term.

Based on my composite of indicators, there is little reason to doubt the long-term validity of the signal.

The daily chart of the iShares Russell 2000 ETF IWM, +0.46%, below, shows why a short-term pullback is possible:

Price has not yet broken out and is at double resistance.

RSI-2, a measure of short-term momentum, is over-bought (short-term risk is elevated).

RSI-35, a measure of longer-term momentum, has not yet broken out.

A retest of the 150-151 zone would be normal. A close below 150 would postpone the rally and allow for a deeper pullback.

For question No. 2: It’s often said that small-caps are more economically sensitive and therefore a leading indicator. In theory this sounds good, but in reality that’s not really the case.

Although the Russell 2000 was first to peel away from its August 2018 top (and has been lagging ever since), the S&P 500 has reached a new high first more often than the Russell 2000 (see chart below).

Conclusion

Readers may remember my mid-term bearish projection published here, and the Russell 2000 breadth thrust certainly does not support this forecast.

In fact, starting in mid-August, I noticed a number of bullish “under the hood” developments likely to cause a bounce and warned that: “We’ve seen bounces catch fire before, and aggressive investors afraid of missing out may grab some long exposure.”

The Russell 2000 sure caught fire, and history suggests it will continue to burn higher over the next year. The over-bought condition and bearish September/October seasonality should, however, provide a lower buy point.

Simon Maierhofer is the founder of iSPYETF and publisher of the Profit Radar Report.

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