There have been rumblings of “the return of small caps” for many moons, but small-cap leadership has still not materialized as we kick off the new year. Today we’ll share three charts to watch, besides the obviously important chart of the Russell 2000 ETF (IWM), to determine when a new leadership phase for small caps is imminent.
The chart of IWM itself appears to be in a neutral state, similar to what we’re observing in the other major equity indexes. A long-term trendline using the October 2023 and August 2024 lows has been violated, but this week we saw a bounce right back above this level. IWM has bounced off the 200-day moving average, as well as the 38.2% retracement of the 2024 bull market, but it still remains below its 50-day moving average.
Financials are One of the Top Sectors in Small Caps
While the S&P 500 is dominated by the technology sector, currently comprising about 32% of the index based on market capitalization, small cap indexes tend to have a more value-tilted sector profile. Financials are the second-largest sector weight after industrials, and a boost this week from earnings wins indicates perhaps a new leadership role for this value-oriented sector.
We can see that a similar trendline for the Financial Select Sector SPDR Fund (XLF) was tested last week and held before this week’s bounce higher. We can also observe a bullish momentum divergence over the last two months, with lower lows in price matched with higher lows in the RSI. Finally, the daily PPO indicator recently generated a bullish crossover, indicating the trend has now reversed higher.
A Resurgence in Biotechs Could Boost the Small Cap Index
While financials have rotated higher this week, the iShares Nasdaq Biotechnology ETF (IBB) remains in a primary downtrend. However, with IBB bouncing off support around $131, this could be a setup for a bullish price rotation.
While IBB has been pounding out lower highs since last November, the price is no longer making lower lows. A bounce off this recent support level, followed by a successful breakout above moving average resistance, could definitely turn this chart from a chronic underperformer to a more compelling space. And since biotechs are one of the largest industry bets in the Russell 2000, renewed strength for IBB could most likely translate to upside movements for IWM.
In the End, It’s All About the US Dollar
While those previous two charts represent large weights in the Russell 2000, our final chart represents more of a macro tailwind for small caps. Mega cap multinational companies, such as the top weights in the S&P 500 and Nasdaq 100, generate a large percentage of their revenues outside the US. So when they go to exchange their non-US revenues back into US Dollars, the stronger $USD chart would mean those non-US revenues are much less valuable in dollar terms.
Small-cap companies tend to generate most of their revenues in the US. Therefore, small cap stocks would not be faced with that currency headwind that could have dramatic effects on mega cap earnings in 2025.
We can see a fairly consistent primary uptrend in the US Dollar since a major low in September 2024. As long as this chart continues to make higher highs and higher lows, the stronger US Dollar could have more and more of a negative impact on the largest US companies. As small caps are fairly immune from this potential headwind, a continued uptrend in the US Dollar would suggest small caps could definitely outperform going forward.
At the end of the day, the chart of IWM will be the most important one to watch to gauge a potential leadership role for small caps. The most bullish signal we could observe would be a breakout for the small indexes! Hopefully, these three charts can be used in conjunction with a thorough technical evaluation of IWM to determine whether small caps can finally take on a leadership role in the equity space.
RR#6,
Dave
P.S. Ready to upgrade your investment process? Check out my free behavioral investing course!
David Keller, CMT
President and Chief Strategist
Sierra Alpha Research LLC
Disclaimer: This blog is for educational purposes only and should not be construed as financial advice. The ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional.
The author does not have a position in mentioned securities at the time of publication. Any opinions expressed herein are solely those of the author and do not in any way represent the views or opinions of any other person or entity.
