Russell 2000: Overbought Is Underappreciated

Last year was a remarkable year for U.S. equities, concluding with a historic two-month uptrend and a meaningful change in character that cannot be understated. Unlike the prior ten months, where the majority of benchmark gains were driven by a small number of mega-cap technology stocks, the explosive move higher over the final nine weeks was broad-based and led by a healthy rotation into previously underperforming groups. Outperformance rotated into smaller caps, equal weight indices, and the REITs, Financials, and Healthcare sectors.  

The catalysts propelling the market’s year-end acceleration were injected via liquidity-friendly measures from the Treasury, two FOMC meetings that reversed the “higher for longer” interest rate mantra, softening inflation & employment data, and, accordingly, a dramatic decline in rates.  

In the early stages of this nine-week uptrend, rare “breadth thrust” indicators were triggered, capturing widespread bearish to bullish price action, technical measures historically proceeded by longer-term uptrends. By year-end, the flagship S&P 500 (SPX) cemented a string of nine consecutive weekly gains for only the third time (2004 and 1989) in 38 years. Since 1970 (53 years!), the only time the SPX exceeded this streak was in 1985, when it strung together twelve consecutive weekly gains. Ironically, the SPX was one of the worst-performing broad-based benchmarks, with a relatively weak total return of 16.2%. The top performers were the Russell Microcap and Russell 2000 indices, which had total returns of 28.3% and 24.2%, respectively. 

In the first week of 2024, broad U.S. equity benchmarks finished lower across the board, led by the small Russell 2000 and Microcap indices, each of which declined 3.7%. For the S&P 500, this ended its streak of weekly gains. This short-term pullback and underperformance by the Russell 2000 seems logical not only because of its robust outperformance over the prior two months but also because its momentum measures were at extreme “overbought” readings (i.e., “buyer exhaustion”), suggesting a near-term consolidation was well deserved.  

There are several ways to measure “overbought” readings, with one of the most common being the relative strength index (RSI). The Russell 2000’s daily RSI peaked on December 14th at 79, its highest in more than six years and amongst the strongest in 20 years. Since 2004, this “overbought” level has only been exceeded during a cluster of eight days in the fall of 2017, twice in November 2016, and twice in April 2010.  

Another way to measure “overbought” price action is by comparing the price with a moving average. On Dec. 26, the spread between the Russell 2000 and its 50-day simple moving average (sma) measured 14.3%. Since its inception 45 years ago in 1978, this ranks as the 47th widest spread. On the face of it, that may not seem like too big of a milestone; however, it falls into the top ½ percentile, which is no small feat.  

More importantly, a closer examination of the other 46 occurrences where the spread was wider than the recent peak of 14.3% is eye-opening, as a high majority (87% - 94%) are clustered near the early stages of major market-cycle lows.  

A summary of the 46 prior occurrences shows the following distribution:

• The sample of four in November 1982 took place just three months after the index bottomed following a 29.6% decline from the 1981 high and marked the very early stages of the 1980s bull market.  
• The sample of 17 in Q1 1991 took place three months after the index bottomed following a 36.2% decline from the late 1989 high and again marked the very early stages of the 1990’s “dot-com era” bull market.  
• The one sample in June 2003 captured the index breaking free from a bottoming process following the bursting of the dot-com bubble, which troughed a year earlier in 2002. 
• The sample of eight in April and May 2009 took place just one month after the bottom of the Global Financial Crisis, once again representing the very early stages of a major market low.
• Thirteen took place in three of the ensuing four quarters following the Covid lows in March 2000.  
  • The sample of nine in May and June of 2020 represents the very early stages (sound familiar?) of the post-covid lows.  
  • The one sample in November 2020 took place in week four of a historic 12-week, 41% gain. This return measured the 3rd best 12-week rolling performance since its inception in 1978. Only the 12-week returns starting at the cycle lows from 1981 and 2009, each measuring 43%, were greater than this 12-week run. 
  • The final sample of three from the post-Covid era took place in January 2021, and while the Russell 2000 did go on to gain another 28% over the next seven months into November, the bear market of 2022 then commenced. Separately, in the first week of December 2021, we published Russell 2000 Technical Outlook: Walking a Slippery Slope.  
• The only outright bearish samples were three clustered together during the same week on March 3, 6, and 9 of 2000. In fact, March 9, 2000, was THE highest daily closing price at the top of the 2000 dot-com bubble.  

The current era for our capital markets is certainly unique relative to the past due in part to the extensive amount of debt and the accompanying measures being taken by the Treasury and the Federal Reserve. We also have the prolonged inversion of the yield curve, the ongoing 20 consecutive monthly declines in the Leading Economic Index, and a looming recession, just to name a few. However, while the economy may still be flashing late-cycle dynamics, the market cycle looks quite different. 

The Russell 2000 peaked in early November 2021, coinciding with the Federal Reserve officially dropping its “transitory inflation” verbiage. It took two years and a decline of 34% before bottoming in the final week of October 2023. While other benchmarks have arguably been in a bull market for nearly a year, from a technical perspective, one could make the case that the Russell 2000 and the majority of its small-cap members are in the very early stages of a new bull market. 

Select short-term indicators such as daily RSI signaled a near-term pullback, like last week’s decline of 3.7%, which was well overdue. The 6% pullback from the late December high has not even retested the 38.2% retracement, a common support level, let alone the 50% or 61.8%.  

The longer-term weekly period shows the breakout from an 18-month range in late December lasted less than two weeks before the index pulled back into the prior range. There is the possibility it may be on a new path toward the bottom of the prior 18-month range. Conversely, the index may just need more time to consolidate before resuming the second wave of the prior uptrend. Given the wide base it is attempting to break free from, a move above the December high could be accompanied by strong momentum, per the adage “the bigger the base, the higher into space.”      

The historical precedence of measures like breadth thrusts and this note’s focus, price versus moving averages, suggest there are reasons to be optimistic in the longer-term outlook. While past performance is no guarantee of future results, and there are no magical indicators suggesting otherwise, the stock market is one of many leading indicators, and its price action since late October should not be underappreciated.

^{The information contained herein is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. All information contained herein is obtained by Nasdaq from sources believed by Nasdaq to be accurate and reliable. However, all information is provided “as is” without warranty of any kind. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.}