Will going small pay off big?

●Small-cap stocks have led the US market higher during the current upswing

●Russell 2000 often shows relative strength after sell-offs

Although it’s a little too easy to say, “Small caps were supposed to do great last year and they got creamed, so it makes sense to buy them now,” the market-leading performance of the Russell 2000 index (RUT) since the late December lows is a useful reminder of a two-part piece of market history:

●Small caps have often outperformed the rest of the market after significant market lows.

●Small caps have often underperformed the rest of the market at the end of rallies, and during downtrends.

First, let’s not get too carried away. Just because the RUT is climbing out of its recent rut at a faster clip than its fellow US indexes doesn’t mean December 24 will be a multi-year market low, and even if that does turn out to be the case, it doesn’t guarantee the RUT will continue to outperform (in fact, history suggests it won’t). Nonetheless, late yesterday the RUT was pushing a 14% gain since December 24, while the Nasdaq 100 (NDX) was up roughly 12% and the S&P 500 (SPX) had rallied around +10%.

Russell 2000 (RUT) and Nasdaq 100 (NDX), 2/12/16–6/23/16. Small cap relative strength

Source: Power E*TRADE

RUT’s relative strength after significant lows is illustrated by the move off the February 2016 lows (chart above). Important point: The RUT’s relative strength vs. the NDX peaked in late June (end of the chart), a little more than four months after the beginning of the rally.

The following chart shows the other side of the coin—the RUT underperforming the NDX during the late-2018 sell-off:

Russell 2000 (RUT) and Nasdaq 100 (NDX), 9/24/18–12/24/18. Russell leads to the downside.

Source: Power E*TRADE

One thought that jumps to mind is that perhaps small-caps can have an upside edge after sell-offs because they often lead the market to the downside. Here are a couple of other potentially useful takeaways:

●Although small-cap relative strength often occurs after significant market bottoms, such outperformance (relative to the NDX) will not necessarily last very long, even during a long-term market uptrend. So, long-side traders in Russell 2000 futures (RTY), exchange-traded funds, or specific small-cap stocks may maximize their edge in the early stages of a market-wide rally.

●Diminishing RUT strength vs. the NDX, and particularly a switch from RUT relative strength to relative weakness, may sometimes indicate the final stages of a bull move. Translation: If you’re convinced a bull move is over—or if the market is already in a downtrend or bear market—short-side small cap plays may offer more bang for the buck.

A final chart provides some long-term perspective, comparing the RUT, NDX, and SPX from the March 2009 lows. Measured from that point, both the RUT and SPX underperformed the NDX by a wide margin, while the RUT had an edge over the SPX during most of this long-term uptrend.

Russell 2000 (RUT) and Nasdaq 100 (NDX), 3/9/09–1/9/19. Big-picture performance.

Source: Power E*TRADE

It’s another reminder that trading is different than investing. Short-term traders certainly need to make hay while the sun is shining, but they also need to be prepared to take cover when clouds appear on the horizon.

As a final aside, there’s been some notable action in small- and midcap biotech stocks recently—fire up Power E*TRADE and check out the moves in BioMarin Pharmaceutical (BMRN), Exelixis (EXEL), Seattle Genetics (SGEN), and Tesaro (TSRO).

Market Mover Update: Yesterday crude oil surged into the middle of its November-December 2018 trading range, while the latest uptick in Dunkin’ Brands (DNKN) pushed the stock into its late-2018 range.

Today’s numbers (all times ET): EIA Natural Gas Report (10:30 a.m. ET). Reminder: Certain economic reports may not be released as scheduled because of the ongoing government shutdown.

Today’s earnings include: Delta Air Lines (DAL), Synnex (SNX).


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