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Does the recent small-cap rally suggest a catch-up play or something more?


The small-cap Russell 2000 index ETF (IWM) has exposure to 2,000 small-cap domestic stocks and has lagged domestic counterparts during 2023. The small-cap gauge has been left behind in 2023, gaining around just 8.08% since the beginning of the year versus 11.15% for the large-cap S&P 500 Index (SPX) and 25.21% for the technology-laden Nasdaq Composite Index (COMPQ).

Both large-cap indexes have outperformed the small and mid-cap indexes due primarily to the mega-cap tech stocks in 2023. The eight (8) mega-cap technology stocks accounted for around 28% of the market-cap-weighted S&P 500 and over 55% of the tech-concentrated Nasdaq 100 Index (NDX).

Nasdaq indexes and mega-cap technology stocks appear to be overbought and technically extended. Despite the recent rally, Russell 2000 stocks are well below their respective peaks.

Historically, small caps tend to bottom months and quarters before an economic bottom. Small-caps and small-cap value stocks are sensitive to the domestic U.S. economy.

The near-term outperformance from small caps and small cap cyclical names hints that recession fears are abating. It also signals a risk-on appetite among investors and traders. Smaller stocks can generate higher returns as they are more volatile than larger market capitalization and more liquid names. They can also fall sharper during market downturns.

The Russell 2000 index may be bottoming, at least establishing a relative bottom against the S&P 500 Index. The recent rebound in the IWM/SPX relative strength trend from the Mar/Apr 2023 bottoms is constructive, suggesting small caps are now participating in the stock market recovery.

The gap-up for IWM on Friday, 6/2/23, comes on the backdrop of another robust jobs report that suggests the potential for a soft versus hard landing. Today, the Russell 2000 index gapped up again, outperforming S&P 500 Index by 2.25 percentage points, its highest spread difference since November 2021.

It is also constructive to see a continuation of broadening rallies outside Technology and the eight (8) mega-cap technology stocks, suggesting an expansion of market breadth. Note that the strong rallies in the financial service names have helped IWM as this sector accounts for around 13% of the Russell 2000 Index.

On another note, the two technology-dominated Nasdaq Composite Index and the Nasdaq 100 Index generated negative outside days at the close of trading on 6/7/23. An overbought condition coupled with relative weakness warns of the start of consolidation.


Although it may still be too early to determine if small caps have bottomed, the severe downturn in this group and the recent relative outperformance against the large caps suggest a catch-up play, at least from a near-to-medium-term perspective.


Source: Chart courtesy of StockCharts.com

Source: Chart courtesy of StockCharts.com


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