US small-caps looking to break higher

Summary:

• US2000 attempting to breakout

• Price moves above prior resistance near 1620

• Major benchmarks remain near record highs

The best performing US stock benchmark on Monday was the Russell 2000 (US2000 on xStation) with the index rallying over 2% and hitting its highest level since October 2018. Gains were seen also across the major benchmarks but its was the small-cap index that caught the attention due to not only the larger relative gain but also the possible breakout higher.

The US2000 has been range bound for much of the year with support seen around 1445 and resistance below 1620 respected until yesterday. The break and daily close above 1620 could be seen as a crucial development technically, and as long as price can remain this level then a breakout rally higher may ensue. Source: xStation      

Typically there’s a fairly good correlation between small and large cap stocks in the US, with many of the factors that drive the broader markets applicable to both. Looking back over the past year we can observe that the correlation was pretty tight during the sell-off in Q4 2018 and this relationship remained throughout the recovery in the first quarter of this year. However, during the spring and summer months where both markets exhibited no clear trends, a divergence began to open up as the S&P500 started to outperform. 

US small caps (shown by US2000) have lagged behind their large cap peers (shown by US500) with the divergence becoming more pronounced over the last 6 months. Source: xStation 

Small-cap companies are defined as those with a market value of less than $2B and they were amongst the best performers during the rally from the 2016 election until last year, when they peaked at an all-time high in August. The market currently trades a little over 6% from the peak. The reasons behind the gains were believed to be that tax cuts would be of greater benefit to smaller firms while the fact that they predominantly have a larger exposure to the domestic economy they would be less susceptible to growing trade tensions. However, softening US economic data and the rising possibility of a recession, signalled by the inversion of the yield curve caused investors to become nervous. 

Small companies are typically seen as less durable to economic downturns, with earnings less consistent, higher levels of debt and also less diversification amongst income streams. All these factors have weighed on performance throughout the year, with improved sentiment on US-China trade providing a greater boost to larger firms. However, after yesterday’s technical breakout and with a pick-up in data of late there is a chance that small caps look to catch up with their larger peers in the months going forward.