Small cap rally: Why this week will be make-or-break for the Russell 2000

Small cap rally: Why this week will be make-or-break for the Russell 2000

For small-capitalization stocks, it’s been a year to forget.

Since Aug 31 of 2018, the small-cap Russell 2000

RUT, -0.56%

 index has fallen more than 9%, compared to a rise of 3.6% for the large-cap S&P 500 index

SPX, -0.07%,

but in September, the Russell’s fortunes began to turn around, and there’s now reason for cautious optimism that a rally in smaller-company stocks is here to stay.

Month-to-date, the Russell 2000 has risen 6.4%, while the S&P 500 has advanced 2.4%, as of Monday’s close.

“Recession fears that were overblown in August have receded, and no recession helps small caps even more than large,” Steven DeSanctis, equity strategist at Jefferies told MarketWatch.

DeSanctis pointed to rising bond yields as evidence that the market believes the U.S. economy will avoid a recession next year, but also predicted that the Russell 2000 will benefit from a Federal Reserve interest rate cut for the second time this year at the conclusion of the central bank’s meeting Wednesday.

“An aggressive Fed should help the backdrop for small caps, as they have outperformed in the past after rate cuts,” DeSanctis wrote in a recent research note. “If housing improves due to lower rates, small caps should benefit way more than large. We estimate 30% of earnings in [the Russell 2000] are from housing related industries, versus 12% for large,” he added.

Meanwhile, small caps still look relatively undervalued compared to large caps. Historically the Russell 2000 has been valued higher relative to the S&P 500 83% of the time.

Though small caps have been undervalued relative to large for many months, DeSanctis argued that investors are now turning their attention to 2020 earnings, helping spark the recent outperformance. He predicts Russell 2000 index company earnings growth could be as high as 10% next year, after a year in which rising labor and input costs, along with the fading effects of the 2017 corporate tax cut, led Russell 2000 earnings to fall significantly year-to-date.

Stephen Suttmeier, technical research strategist at Bank of America Securities argued that the breadth of the rally in small cap stocks “supports the case for a Russell 2000 breakout,” in a Monday note to clients.

“Small cap breadth improved last week with the percentage of Russell 2000 stocks above 200-day moving averages hitting is best level of the year,” he wrote. “A similar setup in 2016 preceded an upside breakout on the Russell 2000 and new highs for the index into late 2016.”

Suttmeier said the key level to watch for the Russell 2000 is a range between 1,596 and 1,618. If the Russell 2000 can break through this level, it would “signal an upside back to the 2018 peak of 1,740.”

The Russell rose 0.4% on Monday to close at 1,584.60, just a few points shy of this resistance level, making this week a potential make-or-break one for the small cap universe.

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