The Russell 2000 index has lifted to a bull market and all-time high this week, signaling the next stage of a powerful small-cap rotation that could continue into year end and beyond. At the same time, this emerging leadership may force funds and institutions to exit overheated tech stocks to free up speculative capital, dropping the Nasdaq 100 into a long period of relative underperformance.
Look no further than the currency markets to find the reason for this bullish development, with the U.S. Dollar Index (DXI) bouncing off two-year range support following a brutal decline in response to the Trump presidency. Domestic issues, including small caps, tend to strengthen and outperform during periods of U.S. dollar strength because multinational corporations become less profitable due to exchange rate headwinds. (For a refresher, check out: An Introduction to Small-Cap Stocks.)
There are dozens of ways to play this breakout, led by the venerable iShares Russell 2000 ETF (IWM), which currently trades more than 22 million shares per day on average. The Vanguard Small Cap Value ETF (VBR) offers an interesting second choice, holding the second highest asset total among active funds while trading fewer than 300,000 shares per day. Market players seeking higher exposure may consider Direxion Daily Small Cap Bull 3X Shares (TNA) or ProShares UltraPro Russell 2000 ETF (URTY), which offers 2X leverage. (See also: Top 3 Small-Cap ETFs for 2017.)
IWM Long-Term Chart (2000 – 2017)
The iShares Russell 2000 ETF came public in May 2000 in the mid-$40s and rallied quickly to $54.60. That peak marked the highest high for more than three years, ahead of a volatile decline that posted an all-time low at $32.30 in the fourth quarter of 2002. It finally broke out to a new high in 2004, entering a rising channel that contained price action into the 2007 bull market high at $85.20.
The fund plunged during the 2008 economic collapse but held above the 2002 low, ahead of a V-shaped recovery wave that completed a 100% round trip into the 2007 high in April 2011. It spent the next two years grinding out a cup and handle pattern at that level, ahead of a 2013 breakout that generated the most prolific gains so far in this bull market cycle. The rally's trajectory eased above $120 in March 2014, giving way to a shallow uptrend that topped out at $129 in June 2015. (For more, see: IWM: iShares Russell 2000 Index ETF.)
It then entered a severe correction, losing ground in a multi-wave decline that came to rest at a two-year low in the mid-$90s in February 2016. A recovery wave into September stalled four points below 2015 resistance, generating a pullback into November, followed by a November breakout that stalled in the low $140s just one month later. The fund carved a narrow consolidation at that level for more than nine months and broke out this week.
IWM Short-Term Chart (2015 – 2017)
IWM fell more than 35 points after topping out in June 2017, coming to rest well above new support at the 2013 breakout in the mid-$80s. The subsequent bounce followed 2007 to 2011 fractal behavior, gaining ground at the same pace as the prior decline. However, it spent little or no time testing resistance in this instance, breaking out within one day of reaching the 2015 high. (See also: Small Caps: Rising Rates Not All Bad News.)
The consolidation into September 2017 carved a shallow rising channel that generated a long series of bull traps. This week's rally finally cleared channel resistance, opening the door to a much stronger price rate of change that could generate upside into $170, or 1,700 on the underlying index. Pullbacks to $142 should be buyable in this scenario, while declines need to hold the 50-day exponential moving average (EMA), currently rising from $140.
The Bottom Line
The Russell 2000 small-cap index has broken out above a nine-month rising channel, confirming last December's breakout while setting the stage for healthy fourth quarter gains. (For additional reading, check out: A Big Battle Among Small-Cap ETFs.)
<Disclosure: The author held no positions in aforementioned stocks at the time of publication.>