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Russell 2000 falters again

Small caps outperform in a bull market. This is a market mantra that has been borne out time and again, so the underperformance of the Russell 2000 against the S&P 500 so far this year, down 2.7% versus a gain of 4.5% for the latter, is a worrying sign.

Graph
Source: Bloomberg

Usually smaller companies see more rapid expansion in times of economic growth, and this sees their shares rise as investors buy in. However, small caps are often the ones to weaken first when those same investors begin to fret about the economic outlook. The poorer performance of the Russell 2000 this year comes after a gain of over 200% since 2009, versus 180% for the S&P 500.

Talk of overvaluation has dogged the Russell 2000 for the past eight months. It flared up in early March as a sign that the bull market was due for a major correction. Data from Bloomberg shows that in March the index’s PE was around 40. It now stands at 53. Clearly, valuations are once again going to be talked about as a concern for this market, fuelling expectations of further losses. In March the Russell 2000 also declined around 9.2%, but so far the index is only down 5%. Compared to an S&P 500 PE of 17.5, the index seems to be overvalued, but small cap companies often trade on higher valuations.

One other way of gauging the potential of further losses in equity indices would be to examine the short interest, ie the number of short trades placed in expectation of further falls. This hit a low for the Russell 2000’s representative ETF, the iShares Russell 2000 index, in February of this year but has steadily risen since then, reaching a high at the end of June as the price recovered. The short interest ratio (the short interest dividend by the asset’s average daily volume) touched a high around 4.5 towards the end of June. This is a level not seen since the final quarter of 2013, from a low of 2.2 at the beginning of February.

Twice this year the Russell has failed to break highs above 1200, making this line the one to watch in any longer-term push higher. What the daily chart also shows is that 1100 has been an area of support so far this year as well, in February, April and May. The latest dip stopped short of this level, so even with the breach of the 200-day moving average there may be grounds for optimism.

The drop through the 200-DMA certainly makes traders more bearish on this market, but with the relative strength index pulling higher from its lows of last week, upward momentum seems to be recovering. Now we need to see a close back above 1145 to reignite the upward move. Any drop through last week’s lows around 1107 would open the way to another attempt to drop through 1100, in which case the 1062 area may become support.

On the hourly chart the recovery of the 200-hour moving average is a bullish short-term sign, even if this puts the index within easy distance of the overbought zone on an intraday basis. The hourly chart points towards 1150 as the next zone to watch for upside resistance.

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