A historic expansion in new highs for small caps

Key points:

• The percentage of small-cap stocks registering a 63-day high surged to one of the highest levels in history
• Similar expansions in new highs produced excellent outcomes, with a 100% win rate a year later
• A small, medium, and large capitalization stock index also recorded a signficant expansion in new highs

Participation is broadening across all stock market capitalizations

Throughout 2023, the prevailing narrative has centered around the notion that seven stocks solely propelled the market's upward trajectory. Although it's undeniably true that these Mag-7 stocks have played a substantial role in the overall gains of the S&P 500, it's essential to recognize that many opportunities have existed outside of a handful of bellwethers.  

One area where opportunities have been limited is small-capitalization stocks. However, investors should take another look at this out-of-favor group. 

On Thursday, the percentage of Russell 2000 stocks recording a 63-day high increased to 48%, reaching the 5th highest level in history. 

Similar expansions in new highs preceded excellent results

When the percentage of Russell 2000 stocks registering a 63-day high increased above 38%, returns, win rates, and z-scores for the small-cap index were outstanding. A year later, the index was higher every time. 

I lowered the signal threshold from 48% to 38% to capture more precedents. 

Should we consider an allocation to small caps?

A comparison between the Russell 2000 and the S&P 500 suggests investors should consider an allocation to small-cap stocks. As always, it is imperative to use relative strength indicators for timing and sector selection.

Every sector except energy has witnessed a positive relative trend score change over the last week. Interestingly, the S&P 600 recorded the most significant jump with a ten-point change.  

Breakouts are prevalent across all stock market capitalizations

Members in the S&P 1500, an index containing small, medium, and large capitalization stocks, recorded the highest expansion in 63-day highs since October 1982.

When 63-day highs expand like now, the S&P 500 displayed excellent results across all time horizons. Twelve months later, the world's most benchmarked index was higher in all but one case.

What the research tells us...

Since peaking in 2021, the Russell 2000, a broad measure of small-capitalization stocks, has been a perennial underperformer, succumbing to the pressure of higher interest rates. However, small-cap stocks recently exploded higher, with the outlook for rates looking more favorable, recording a historic expansion in 63-day highs. After similar breakout conditions, the Russell 2000 was higher a year later every time. The S&P 1500, an index containing small, medium, and large-cap stocks, also registered a signficant expansion in 63-day highs, reaching the highest level in over 40 years. Similar alerts were exceedingly bullish. Remember, markets rarely, if ever, peak when new highs are expanding, which is the case now.