Small-Cap Rally May Be Coming to an End

The Russell 2000 small-cap index has underperformed large-cap benchmarks by a country mile in recent years, with big corporations reaping the benefits of the largest tax cut in history. At the same time, mega caps like Alphabet Inc. (GOOGL) and Amazon.com, Inc. (AMZN) have taken control of thousands of market niches previously filled by small businesses, making it nearly impossible for them to compete.

It's not surprising that the iShares Russell 2000 ETF (IWM) posted larger losses than big caps in the first quarter selloff, given those steep headwinds, dropping 44% compared to 30% for the Invesco QQQ Trust (QQQ) and 33% for the SPDR S&P 500 ETF Trust (SPY). The second quarter bounce has been relatively weak for small caps as well, despite a few rally days that market analysts have attributed to heavy buying by the recently dubbed "Robinhood traders," also known as young folks who opened free trading accounts with government stimulus checks.

The three-month uptick in small caps appears to be coming to an end around the 200-day exponential moving average (EMA), which marks a common target after extreme oversold technical readings. It's also hugging the .618 Fibonacci selloff retracement level after stretching into the .786 retracement, carving a common harmonic pattern that predicts renewed downside. That hasn't happened yet, but we're headed into a second quarter earnings season that is likely to generate less enthusiasm than the first quarter due to over-optimism about the post-shutdown era.

IWM Long-Term Chart (2000 – 2020)

The index fund came public in the mid-$40s in May 2000, just two months after the end of the bull market, and topped out in the mid-$50s in July. The subsequent downtick picked up steam through the rest of the year and into the third quarter of 2001, when the Sept. 11 attacks generated a tradable low in the mid-$30s. The bounce failed in the second quarter of 2002, yielding a selling climax that undercut the prior low before posting a long-term bottom at $32.30.

That marked the lowest low in the past 18 years, ahead of a bull market impulse that reached the 2000 peak in the third quarter of 2003. An immediate breakout signaled the start of a fruitful period, with the fund adding steady gains into July 2007, when it topped out at $85.20. The subsequent decline accelerated during the 2008 economic collapse, before settling just two points above the 2002 low in March 2009.

A recovery wave into the new decade completed a round trip into the prior high in 2011, but the fund failed to mount that barrier until 2013. The subsequent uptrend slowed in 2014 and stalled out one year later, generating strong resistance in the $120s. It mounted that level after the 2016 presidential election, carving a three-legged advance that posted an all-time high at $172.39 in August 2018. Underperformance accelerated after the peak, with the SPY and QQQ posting new highs in 2019 and 2020.

IWM Short-Term Chart (2018 – 2020)

A lazy uptick into 2020 stalled three points below the 2018 high, giving way to a vertical downdraft that ended at a four-year low just above the deep 2016 low. The subsequent bounce tagged the .786 selloff retracement on June 8 and reversed, settling at the .618 retracement level, 200-day EMA, and trendline going back to 2009. Price action has carved a rising channel at the same time, with a decline through $136 having the potential to set off a major sell signal.

The on-balance volume (OBV) accumulation-distribution indicator topped out in August 2018 and entered a modest distribution phase, returning to resistance in the first quarter of 2020. Short covering and bottom fishing supported an equally strong accumulation phase in the second quarter, lifting OBV to a new high. This bullish divergence should limit selling pressure during a downturn, but it might not be enough to preclude a test at the March low.

The Bottom Line

The Russell 2000's oversold bounce may be coming to an end, raising the odds for renewed downside in the third quarter.

Disclosure: The author held no positions in the aforementioned securities at the time of publication.