Russell 2000 Consolidates Further: How Should You Play It?

Russell 2000 Consolidates Further: How Should You Play It?
Russell 2000

With all attention being drawn to large-cap stocks, especially as the Fed’s message of transitory inflation begins to stick in the minds of investors, it is not surprising to find small-cap stocks being dumped left in the rot. Despite starting the year on a blistering note, the Russell 2000 seems to have lost momentum in comparison to other major indexes.

Investors had gotten cozy with the narrative that small-caps would outperform the market this year, but that optimism faded when interest rates started to drop, and tech companies posted blow-out earnings.

For the past six months, the small-cap index, Russell 2000 has been consolidating between the 2150- and 2350-point range.  The index has remained largely flat within this time, returning a paltry -0.02%.  This contrasts the performance of its larger peers such as the S7P 500, Dow, and Nasdaq that have returned 13%, 12%, and 7% within the same period.

Also, while other indexes have set new all-time highs within the last two months, the Russell 2000 has been reclining from its March highs. The index is also trading below its 50-day and 200-day SMAs which indicates that there is a lot of bearish pressure on small-cap stocks. The MACD indicator has been in the red zone since late March, while the RSI indicator is nestled halfway between the overbought and oversold zones.

Against this backdrop, bearish investors seem to be doubling down on bets against small-cap stocks. Short interest on small caps has risen to 11% after falling to a two-year low in March when the index posted a new all-time high at the height of the rotation into value stocks.

For value investors whose hunting ground is the Russell 200, the recent performance of small-capped stocks begets the question: how should I play it now? Here are several ways investors can invest in the Russell 2000 in the coming months.

Stand back and wait

In technical analysis, one of the most dangerous times to place a trade is when the trend lines show consolidation. This is because you do not know where the break might occur. It may occur to the upside, meaning that it has broken resistance, or it may occur to the downside meaning that it has broken support.

As such, when the chart shows consolidation, this is a chance to stand back and observe. Given the current level of the Russell 2000 which is currently trading below its 50-day and 200-day moving averages, this should act as an incentive to stand aside and watch for any significant break-out.

Stick with value stocks

A lot of value stocks are currently mispriced, as attention has been focused on growth stocks. This has presented opportunities for investors to profit from. Also, with fears of inflation looming, value stocks provide steady cash flow in the form of dividends which can be used to offset the erosion of value.

Also, compared to the broader index, the Russell 2000 value index (RUJ) has posted decent returns of 7% in the last 6 months, which is similar to what the Nasdaq has returned within the same period. As such, small-cap value stocks remain a good play for investors seeking exposure to the Russell 2000.

Sector bets

Various sectors are bound to perform better than other sectors. Especially if you want to place bets in an economical sensitive index like the Russell 2000. Sectors such as Healthcare, Industrials, and Utilities are a good place to hunt for bargains as they would gain the most when the economy fully reopens and all the noise about inflation wears off. Plus, the share prices of companies in utilities and industrials appear dirt cheap compared to their 2019 levels.

‘Small-cap effect’ still exists

The small-cap effect refers to the notion that small-cap stocks tend to outperform large-caps. This was a thesis put forward by Dartmouth finance professor Kenneth French. He opined that Since the mid-1920s, 10% of stocks with the smallest market caps have beaten the largest 10% of stocks by an annualized margin of 2.4%.

This feat has also been observed in the S&P 500 where the stocks at the lower end of the spectrum have outperformed those at the upper end. Though the recent events in the market from last suggest otherwise, this can be a good play for bargain hunters when the economy fully recovers. As such, investors in the index should sit tight and maintain their positions.

Macros favor small-cap stocks

Despite being left in the dust by investors, there is a strong possibility of growth for small-capped stocks. When economic growth is above its long-term average (as it is now), small-cap stocks tend to outperform their larger capped counterparts. The earnings growth currently experienced by small-cap companies is expected to continue through till early 2023 when the Fed may raise interest rates. Plus, analysts forecast that earnings from Russell 2000 companies would quadruple from a year earlier. This beats the forecast earnings of S&P 500 earnings companies which have been projected to rise by about 25%.

Final word

Even though the Russell 2000 has been marking time and trading sideways in the last six months, investors should not give up on small-cap stocks just yet. If the economy keeps up with its momentum, then small caps would definitely get their mojo back. value investors and those endeared to small-cap stocks have to be content with playing the waiting game for now.

The rotation back into tech and other large capped stocks does not look like easing off anytime soon. And with the Delta variant looming on the horizon, and inflation stoking concerns within the investment community, this may lead to the further unwinding of small-cap stocks. However, if you are looking for cigar-butt stocks that still have some puff left in them, then by all means invest in the Russell 2000 and seat tight.

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