Blue Haven

This area of the market is acting bullish

The stock market has continued to rally so far in 2024 and there are encouraging signs that it can keep going. One of the positive signs is that small cap indexes are starting to act better after years of poor performance. In the three years ending April, 29, the S&P 500 had returned 27% while a small cap index had fallen 9.50%. That is some of the largest divergent performance on record. But let’s take a look at what’s going on in the market that suggests better days are ahead for small cap stocks.

A simple case of acting better

One of the ways we evaluate markets is by identifying price behavior. For example, if a security is trading in a range of $90-$100 for months we could simply say that it’s having a hard time going above $100. If that security then starts to go over $100 and up to $101, $102, etc.. we can say the price behavior is improving; its going above a level it hasn’t been able to stay above. This is where you might read that Stock XYZ is “acting bullish.”

The example above sums up what we’re starting to see in the small cap space. We’re showing two ETFs below, IWM and IJR, that track two popular small cap indexes: the Russell 2000 and the S&P 600. You can see that each one has been in a trading range for more than two years, but they’ve recently started to spend time above the top end of their ranges:

IWM traded between $160-$200 for two years but is now starting to stay above $200.


IJR traded between $85-$105 for two years but is now starting to stay above $105.

In each of these cases, IWM and IJR are starting to act more bullish. This is a good sign.

How does this compare to the S&P 500 and why?

These small cap indexes were some of the best performing segments of the market following the Covid bottom in March 2020. From the lows of 2020 to the highs of 2021, these small cap indexes went up 140%. That compares to a 120% rally over the same time for the S&P 500. But since the market’s overall bottom in October of 2022, these small cap indexes have lagged behind the S&P 500.

One reason for the varied performance is that larger companies that are in the S&P 500 have been able to better withstand the negative effect of higher interest rates. Apple and Microsoft, for instance, do not lean on borrowed money to fund operations and future growth initiatives. Smaller companies, on the other hand, often have to borrow money.

As the cost of borrowing money soared during 2022-2023 these smaller companies were navigating a tougher operating environment. You can think of this similar to the way rising mortgage rates have affected lower-income households at a disproportionate level compared to wealthy families.

Now that interest rates have stabilized, albeit at higher levels, these smaller companies may have had enough time to fully adjust to the new economic environment they are operating within. Perhaps that’s one reason we are starting to see IWM and IJR acting more bullish in recent weeks. Going forward, we think that if interest rates remain steady, even at high levels, small cap indexes can perform very well. The following ETFs provide exposure to the small cap market and are all low-cost: SPSM, IJR, IJS, IWO, IWN, DFSV, IWM. We have between 10-15% of our equity portfolios in such ETFs and are optimistic about the months and years ahead.

 

Read more: Small Caps Show Signs of Life

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