A recovery in small-cap participation bodes well for the cyclical advance

Key points:

• The percentage of Russell 200 stocks above their 50-day average cycled from below 5% to above 75%
• Similar recoveries in participation saw the small-cap index rise 100% of the time over several horizons
• The Russell 2000 tended to outperform the S&P 500 after similar signals

Participation is broadening across economically sensitive small-cap stocks 

Small-cap stocks have shown a marked improvement in participation, with over 75% of Russell 2000 constituents now trading above their 50-day moving average, an impressive rebound from a deeply oversold condition when fewer than 4% were above that level. 

This surge indicates expanding market breadth, hinting at rising investor appetite for riskier segments of the equity market. Such widespread participation across a diverse range of smaller, more economically sensitive companies typically occurs during the initial stages of a cyclical advance, signaling that the recovery is not limited to a narrow segment of the market but is instead gaining traction across a wider swath of stocks.

As shown in the chart, the Russell 2000 has delivered a 29% annualized return when more than 75% of its stocks are above their 50-day moving average. 

Similar recoveries in medium-term trends preceded excellent returns

Although the sample size is small, whenever the percentage of Russell 2000 stocks above their 50-day average cycled from below 5% to above 75%, the widely followed small-cap index rose 100% of the time over the next two, three, and twelve months. 

Many of the historical comparisons stem from post-recession bear markets, which differ from today's backdrop. As such, it may be more appropriate to align expectations with the signals in 1998 or 2019, where the results, while positive, were less robust. 

Over the next year, the Russell 2000 never experienced a drawdown greater than 10%, while it rallied more than 10% each time. 

The S&P 500 displayed excellent results after participation trends for small-cap stocks recovered, rallying 100% of the time over the subsequent two, six, and twelve months.

The Russell 2000 consistently outperformed the S&P 500 over the next year. However, as previously mentioned, the more meaningful gains largely followed recoveries from recessionary bear markets. If 1998 and 2019 offer better comparisons, investors looking to play catch-up via the Russell 2000 ETF (IWM) should implement disciplined risk management controls, such as stop-losses. 

What the research tells us...

Participation is broadening among small-cap stocks, a bullish development for these economically sensitive shares and the broader market. Historically, improving breadth has often signaled increased risk appetite and a healthier market foundation. However, one key concern remains: interest rates continue to hover near the upper end of their multi-year ranges. Elevated rates have been a persistent headwind for small-cap companies, which are typically more sensitive to interest rate fluctuations. As a result, I'm viewing this signal more as a trade to rent rather than a long-term investment to own. The duration of the opportunity will likely hinge on the path of interest rates. Any meaningful easing would help sustain and extend the rally from here.