Small cap stocks, along with their primary index the Russell 2000, have had a hard time of it, ever since the COVID pandemic began in 2020. First, mega cap growth stocks became the rage, then, just when value shares—which trade on the Russell 2000 Index—looked to be benefiting from the reflation trade late last year, the US Federal Reserve pivoted on its path to interest rate hikes, signaling the first increases would come in 2022, and small caps got pummeled again.
Of the four main US indices, the Dow Jones, S&P 500, NASDAQ and Russell 2000, only the small cap index has slipped into bear market territory. That occurred when the benchmark fell 20.94% between its Nov. 8 record close and its closing price on Jan. 27.
As a frame of reference, the second worst-performer has been the NASDAQ 100. The tech-heavy index fell 15.1% from its Jan. 4 record to its Jan. 27 close; the SPX dropped just 9.8% over a similar timeframe, between its Jan. 3 record and Jan. 27 low, not even entering correction territory, which starts at -10.00%. Finally, by the above measures, the mega cap Dow has outperformed, retreating just 7.24% between its Jan. 4 record and Jan. 27 close.
The Russell 2000 is lagging for a variety of reasons: small caps are sensitive to rising labor costs and escalating inflation. They also lack the accounting flexibility available to the multinational mega caps listed on the Dow Jones. Plus their position as domestic companies lacking in global exposure makes them more vulnerable to the economic cycle.
So, is JPMorgan Chase strategist Marko Kolanovic's recent positive call on beaten down small caps, which he considers a buy, correct?
We don't think so. First, the 20% drop from its record which has planted the small cap index into a bear market, is likely to sour sentiment on the Russell 2000. In addition, the index's technicals are pointing to an ongoing downturn.
The Russell 2000 has formed a rising wedge, bearish after its initial plunge. The placement of the pattern suggests the rising channel will be broken as the index's slump accelerates.
Last month, the 50 DMA fell below the 200 DMA, triggering a Death Cross. Since then the 100 DMA also fell below the 200 DMA, putting the three primary MAs in a bearish pattern.
This occurred as the benchmark fell slightly out of its rising channel after the small-cap index crossed below its rising trendline for the first time since the March 2020 bottom.
The rising wedge would require a downside breakout to trigger the down-sloping chain reaction. Otherwise, the price could still retest the falling channel top, which coincides with the previous, slightly rising range.
Trading Strategies
Conservative traders should wait for the index to complete the wedge or for the price to retest the top of the falling channel with resistance, followed by a failed rally.
Moderate traders would be content with either a return to the wedge's channel top or downside breakout.
Aggressive traders could go short now, provided they are willing to absorb the risk of a failed wedge and a return to the channel top. Money management is key. Here are the basic requirements for a coherent trading plan:
Trade Sample – Aggressive Short Position
- Entry: 2,045
- Stop-Loss: 2,055
- Risk: 10 points
- Target: 1,945
- Reward: 100 points
- Risk-Reward Ratio: 1:10