Time to Buy the Small Caps?

This year has been all about large cap growth. Behind the extraordinary gains by stocks like Apple, Microsoft, Alphabet, NVIDIA, Amazon, Tesla, and Broadcom, the majority of stocks have gone nowhere at all. The NASDAQ Composite has risen nearly 30%. The Dow Jones Industrial Average is mostly flat.

Somewhere in the middle lie the small caps.

The Russell 2000 was the first of the major US stocks indexes to trough last year: the S&P 500 bottomed in October, but the small caps managed to do so last June. Since then, though, they’ve been stuck in a year-long consolidation range, trapped between the pre-COVID highs and the March 2022 lows.

The Russell 2000 is tilted toward value, which explains some of its underperformance. And that relative weakness was among the bears’ favorite talking points: “How could anyone be bullish stocks if the small caps were closer to breaking down?”

But that weakness hasn’t been constant – over the first two months of the year, the small caps actually tracked big tech step-for-step! It wasn’t until March (when banking stresses truly came to the forefront) that the trouble started, and the index found itself down in the doldrums with the Dow.

Over the past two weeks, though, something has changed. The Russell 2000 is the leader so far in June, rising 6.5% and outpacing even the mighty mega caps.

Is it time to buy the small caps?

Here’s one chart that says we should. The ratio of the Russell 2000 compared to the S&P 500 is rallying off support at the COVID lows. Last time we were here, the small caps went on a 12-month, 40% run of outperformance vs. the benchmark index. Who’s to say they can’t do it again?

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Especially impressive is that big bullish momentum divergence at the lows. Momentum actually troughed back in the middle of March and failed to even approach oversold territory at the most recent low! Divergences don’t get much better than that.

Of course, divergences mean nothing without price confirmation, and when we take a shorter-term look at the chart above, we can see how stiff the near-term resistance for this ratio is:

The lows from last spring are the level to watch. If the small caps are able to move above that level on a relative basis, they’re probably knocking on the door of new 52-week highs. And that could just be the start of their outperformance.

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