High times for small caps

Small caps have been knock-knock-knockin’ on heaven’s door for a few months. Yesterday, someone finally answered.

When tax reform was transitioning from possibility to probability late last year, one of the commonly held opinions making the rounds in the marketsphere was that small-cap stocks were one of its most likely benefactors. This wasn’t just idle trader chatroom gossip, but the public assertion of some of Wall Street’s heaviest hitters.1

Index comparison, 12/30/16 – 1/2/18. Russell 2000 price chart, with SPX and NDX

Source: OptionsHouse

Small caps had a fine 2017—the Russell 2000 index (RUT) gained 13%—but trailed the broader market, not to mention tech (see chart above). Tax overhaul was expected to flip that script. Small-cap companies tended to shoulder relatively heavier tax burdens because they were unable to tap into the sophisticated tax strategies available to their large-cap brethren.2 Tax overhaul, the theory went, would remove this relative disadvantage and turbocharge small-cap stocks. Cue up the Russell rally.

Well, that didn’t happen—at least in terms of stock performance.

Or did it?

The Russell continued to lag as the US market powered to record highs into late January, but now—after a market correction and a four-months-and-counting consolidation—the RUT finds itself with the year’s second-largest year-to-date US index gain (around +5.4%, trailing only the Nasdaq 100). And more conspicuously, the RUT hit a new all-time high and close yesterday, topping its previous peak from January 24 after making two previous runs at the record, in March and April:

Russell 2000 (RUT), 11/20/17 – 5/15/18. Russell 2000 (RUT) price chart. New all-time high

Source: OptionsHouse

For now, though, let’s forget about any long-term relative strength considerations and focus on the here-and-now: What, if anything, may a new high in the Russell 2000 imply in the short-term?

A logical way to address that question is to look at what the RUT has done after similar milestones—no, not other all-time highs (that’s too exceptional), but other breakouts of similar magnitude. In this case, the RUT pushed above its highest price in 78 trading days, and its highest close in 79. For simplicity, let’s round things up and see what the index has done after making a new 80-day high and close—that is, the highest intraday high and closing price of the past 80 days after a day that didn’t fit that bill.

The following chart compares RUT’s price action in the five days after the 363 other 80-day high/close breakouts since 1988 (green) to all the index’s one- to five-day price moves during that period (black). The two lines in the top half of the chart show the median returns from the close of the breakout day to the following five closes along with the median returns for all one- to five-day periods; the bottom half of the chart shows the percentage of times RUT closed higher at each daily interval after breakouts vs. the index’s overall percentage of higher closes. Long story short: the RUT has tended to have a little more “oomph” than usual after new 80-day high/close breakouts.

RUT after new 80-day high/close, 1987-2018. Russell breakout performance. Record highs. Momentum after breakouts

Source: OptionsHouse (data)

The post-breakout performance exceeds the index’s historical benchmark at every daily interval. For example, the median return three days after breakouts was 0.43%, more than twice the Russell’s overall three-day median return of 0.17%, while the index was higher 63% of the time after the breakouts vs. 54% for all three-day periods.3

The Russell’s new record will likely get a good deal of play in the financial media, so there’s also the “sentiment” factor to consider—momentum and records can whip up enthusiasm. As traders who have been active in recent months know, the news of the day can derail the market’s expected trajectory regardless of what historical patterns suggest. But robust patterns such as this one merit attention.

Yield watch: A sharp jump in the benchmark 10-year Treasury yield (to 3.094%) was widely fingered as the culprit in Tuesday’s stock-market downturn, but as was the case the day after the yield pushed above 3% for the first time in more than three years on April 24, the equity market’s nerves appeared to steady yesterday despite another day of 3%-plus yields.


Click here to log on to your account or learn more about E*TRADE's trading platforms, or follow the Company on Twitter, @ETRADE, for useful trading and investing insights.

1 CNBC.com. These stocks will benefit the most from tax reform: Goldman Sachs. 9/28/17.

2 Forbes. 18 Potential Stock Winners From Tax Reform. 12/19/17.

3 Supporting document available upon request.