Small-cap stocks have had a good run through the end of 2023. They have been chronic underperformers for years, languishing as larger-cap indexes hit new highs. However, that is over and small caps are indeed leading the way at present. Given the the way money is flowing into small cap stocks, the fact that the index has broken out of its multi-year range and its correlation with falling interest rates, I believe the iShares Russell 2000 ETF (NYSEARCA:IWM) is a great long-term opportunity until 2024.
Before we get into the bull case, there is an important short-term caveat, regarding extreme overbought conditions and out-of-control sentiment. However, once these temporary issues are resolved, the IWM is expected to return to racing.
A major breakthrough
IWM was in a range of around $160 to around $197 for the a good part of two years, as you can see below in the weekly chart. Keep in mind that the Nasdaq (COMP.IND) and S&P (SP500) indices reached new highs during this period, while the IWM was simply range-bound. But that is no longer the case.
The triple top at ~$197 has been largely breached, and IWM now sits at $204, trading above the breakout range for a few weeks now. In my opinion, this time frame before the previous trading range confirms the breakout.
I noticed that the weekly PPO is actually quite low despite the fact that we’ve seen an absolutely epic rally over the last couple of months, and on the weekly chart IWM can go very, very far before getting overbought . This is exactly what I think is going to happen.
If we zoom in on the daily chart, we can see high levels of bullish behavior, but plenty of reasons for caution in the short term.
I have noted the breakout level with the support lines plotted below, so you can see the line in the sand for the bulls. I’d really like to see IWM come back and test the $197 zone – or something close to it – and then bounce back up again. Whether or not we get this remains to be seen, but ultimately, as long as IWM is ahead of the previous trading range, it’s a buy.
Caution is warranted with the extremely overbought nature of the index at present. Take your pick, but basically everything calls for a certain amount of time off. The clue is astonishing 13% ahead of its sharply rising 50-day simple moving average. The PPO is 3.6, which is the highest value we have seen in some time. The 14-day RSI is still above 70, well into overbought territory.
While these indicators show that IWM has been under relentless buying pressure, it is also very indicative of bullish market behavior. So while I think IWM needs a pullback to consolidate some of these recent gains, it also gives me a lot of confidence that this breakout is the real deal and that IWM will continue to advance next year.
The feeling is extremely tense
There are many ways to measure sentiment, and they all have their merits. However, I prefer objective surveys that simply track the flow of money rather than sentiment surveys, for example. Charts don’t lie, and below I have a selection of sentiment indicators that all point to one thing: that bullish sentiment on Wall Street is extremely widespread. Since sentiment is a contrarian indicator, I am on high alert for a pullback.
Before I review them, let me reiterate once again that none of this changes my view that IWM is a better buy than $197; this is simply a short-term warning.
The first panel simply represents the 50-day rate of change of the IWM. This is the cumulative price action over the last 50 days, represented as a line. We can see that the most recent reading of +17% is stretched. This is by no means a sell signal, but it does show that the bullish action we have seen has been rather one-sided.
The second panel is the bullish percentage index for the S&P 500. I know the S&P 500 and IWM are not the same thing, but these sentiment indicators apply to all stocks, and their signals are very valuable for the IWM as well.
The BPI is currently 82, which very reliably marks the stocks’ short-term highs over the past two years. This doesn’t mean it can’t go higher, but the chances of a pullback are quite high based on how reliable this signal has been in the recent past.
The bottom two panels represent the percentages of S&P 500 stocks over their 50-day and 200-day moving averages, respectively. Again, these are quite reliable in terms of announcing short-term highs and lows, and right now both are at extreme levels that have generated short-term highs.
Sentiment is, in my opinion, the biggest reason to be cautious about stocks right now. When trading is as one-sided as it has been recently, I worry.
Interest rates and seasonality
There are other considerations besides the price chart itself and short-term sentiment issues, and we’ll look at them now. While sentiment is negative in the short term, interest rates and seasonality are positive in the medium term and, again, support my Buy rating on IWM. Let’s start with a chart of the 10-year Treasury rate (10 American years).
We all know that rates fell months ago and are well below their previous highs. This has been great for stocks, but check the correlation with IWM in the bottom panel. This means that over a rolling 50 day period, the IWM and the 10-year Treasury have a correlation of -0.96which means they move almost perfectly in opposite directions to each other.
As long as the 10-year yield remains below this critical level of between approximately 4.00% and 4.10%, based on this data, the IWM enjoys an upward tailwind in favor of rates.
Finally, seasonality also favors the bulls. Below is data from the last five years, which shows that January is generally a good month for small caps.
The average January gain over the past five years is 2.7%, or 32.4% annualized. IWM’s average annualized gain per month for the entire year over this period is 12.8%, so January is nearly three times as bullish. This suggests that this breakout rally has some staying power, at least over the next few weeks. Things start to get dicey in February and March, so that’s definitely something to keep in mind, but for now, this rally seems to hold some weight for me.
The rally we’ve seen in small caps over the past couple of months has been absolutely breathtaking. Money is very clearly flowing into the space, and as long as IWM stays above $197, it’s a strong buy in my opinion. That said, we are facing some near-term issues that I find quite concerning, and I would really like to see a slight pullback and consolidation above $197 before the rally continues.
I’m placing a large buy on the iShares Russell 2000 ETF, with the caveat that in the short term – I’m talking days, not weeks – the sentiment is unsustainable. But once that’s out of the way, get dizzy.