The Secret Behind Russell 2000's Performance

Small-cap stocks tend to be more volatile, so it's no surprise the Russell 2000 underperformed last year but has been doing better since Jan 1st. Where to now?

Small Caps on the Rise

Historically, small-cap stocks tend to outperform during extreme economic turbulence like high inflation and high interest rates. This is generally understood because of the perception that smaller companies are more noble and able to adjust to changing circumstances. During periods of economic growth, larger firms tend to do better. Of course, small-cap stocks also tend to be seen as higher risk and underperform during periods of risk aversion. 

That pattern appears to be matching so far of late. The Fed insists it will keep rates high for the rest of the year, while economists forecast that inflation won't be under control for at least a couple of years. Not surprisingly, there is renewed interest in smaller-cap stocks. They can also capture headlines, as the Russell 2000 contains a lot of breakout medical, pharma and tech stocks, which can appreciate rapidly in a short period of time. For example, two small-cap stocks that more than tripled their value last year are Madrigal Pharma and TransMedics. More astonishing are the 2023 year-to-date 207% rise of Faraday Future Intelligent Electric and 141% pump on Volta Inc. 

The Reality of Investing in Small-Cap Stocks

Those pharma stocks that rocket in value after getting marketing approval or positive Phase III study results often get much attention. Unsurprisingly, there is a lot of interest in finding the next BioNTech that will skyrocket. But often, that can be akin to luck or requires substantial research into a particular niche area to make an educated guess on which medical trial will work out. 

But the breadth of the Russell 2000 offers a wide range of options, including many so-called "value stocks" because they have low P/E ratios. They might not provide flashy EPS or stock price surges, but they can still offer an attractive return. Often they remain small companies simply because they are targeting a relative niche market, such as Orchid Island Capital, which invests in agency residential mortgage-backed securities (RMBS). Since large institutional investors tend to focus more on large-cap companies, there can be less competition in the small-cap arena, especially for a company with a nearly 20% growth year-to-date and a p/e ratio of 4.0.

The bottom line is that small caps offer better returns but at a higher risk. Investors venturing into this arena are even more reliant on having healthy money management practices.

Russell 2000 in Falling Flag Until Otherwise 

For now, Russell 2000 appears to be in a falling flag pattern, with the upper trendline offering short-term clues on whether the pattern remains valid. Breaking past its top won't necessarily invalidate it, but it will increase the chances of a rectangle top at 2040. Unless this also gets tapped, the breakout leads to a valid channel breakout, targeting the measured move length at 2280.

Inversely, a rejection could see the 1900 handle being revisited, but if that's lost, the index could head all the way down to the lower channel near the 1800 handle. This would encourage bears to short the index to its 1630 low, if not lower, to confirm the flag pattern. However, bears must take control of 1730. Any leg failing to regain that support would be considered a pullback.

with 0.8722 as a last resort. 

Source: Spreadex

Key Takeaways

The Russell 2000 is seeing a resurgence in interest due to the Fed keeping rates high and inflation remaining an issue. There is a range of options offered by the Russell 2000, including breakout medical, pharma and tech stocks, and value stocks with low P/E ratios. But while small-cap stocks provide better returns at higher risk, proper money management practices are key for success. Currently, Russell 2000 is in a falling flag pattern, with potential outlooks targeting either the 2280 or the 1800 handle, depending on the breakout direction.