Small-Caps Catch Second Wind in Broad Tech Rally

As the tech rally continues to broaden out, small-cap stocks have been able to catch up a second wing during this expanding cycle despite typical spring doldrums.

Time to Rise

The premier index on US small-cap stocks, the Russell 2000 Index, experienced a pullback in April before staging a rebound in May. Analysts have noted that the index appears undervalued based on historical context after many companies reported better-than-expected earnings in Q1. One trend observed is that a small group of stocks rose quickly last year in a narrow market, but gains have broadened out in recent months, suggesting small caps could rise further. This justifies the Russell 2000's outperformance.

The market took advantage of some secular trends in May, sending the index as high as 8% at some point. Some analysts pointed to stronger momentum following April's pullback, as the saying "Sell in May and Go Away" may have come too early. Naturally, the downward trend in inflation also took over many headlines, putting the Fed on track to start easing policy as soon as September. However, markets received a bout of cold water yesterday after US PMIs pointed to stubborn inflation, pressuring the small-cap index.

Riding the Tide

Investors have become increasingly optimistic about the US economy following the relatively modest growth in the first quarter. The Fed's GDPNow estimate for the second quarter forecasts a substantial economic acceleration to 3.6%. While this may maintain inflationary pressures, normalisation of the labour force with gently rising unemployment could strike the optimum balance where the economy expands yet prices remain stable enough for the Fed to reduce interest rates towards the average of recent decades. This potential environment may provide significant opportunities for the market, especially for smaller-cap stocks.

Analysts refer to historical trends suggesting that a broad increase in equities led by the Russell 2000 index could materialise this year. However, some factors may also pose challenges. High fuel costs, geopolitical uncertainties, and questions surrounding the election may present possible reversals. While the premier small-cap benchmark currently has historically low valuations, the benchmark S&P 500 and Nasdaq indices presently have historically high valuations. The key question is whether small caps will appreciate to match higher valuations or larger indices will moderate toward historical levels.

C&H on the Horizon

The current price action reveals the characteristics of a cap-and-handle (C&H) pattern. Support at 2020 implies the small-cap index may rise past 2150 towards 2200 and beyond, but it assumes the pullback to 1900 finished a flag formation following an ending wedge. Consequently, a break below the 2000 handle and subsequent swing could trigger a deeper correction towards 1800 without invalidating the prior inverse head-and-shoulders bottom formation.

Source: SpreadEx / US RUSSELL 2000

Key Takeaways

The Russell 2000 Index experienced a pullback in April before rebounding in May, suggesting further potential rises for small caps. It still appears undervalued historically after many companies reported better-than-expected earnings. With gains broadened out in recent months, investors have become increasingly optimistic about the US economy following modest first-quarter growth. If inflation stabilises with gently rising unemployment, this could provide significant opportunities.