The Russell 2000 is a Momentum Trade Now

Summary

• We expected the Russell 2000 rally would slow in 2021, but instead it has outrun the S&P 500 by nearly 10% since yearend 2020.
• Historically, the Russell 2000 takes about a year to ‘catchup’ to the S&P 500 after a significant selloff, then it typically to performs roughly in line.
• The Russell 2000 long-term price return has recovered to 110% of the S&P 500, which it last reached before the December 2018 selloff. Historically, sustaining gains much beyond that level is difficult.

Market Implications

• We reiterate that the Russell 2000 index is unlikely to keep outperforming the S&P 500, and certainly not at the rate seen so far in 2021.
• Still, momentum may drive the Russell 2000 a bit higher. There is little point standing in front of a train, so we would continue holding positions in Russell 2000 ETFs, such as IWM or VTWO, for now.

The Russell 2000 Has Been Unstoppable in 2021

On 11 January, we published a note pointing out that the Russell 2000 equity index (RTY) had handily outperformed the large-cap S&P 500 (SPX) since the US election in early November. And we said it was likely to move more in line with the SPX going forward.

That suggestion worked for a few weeks. Then the RTY muscled higher during much of February and then March after the late February rate-driven selloff (Chart 1). It is up about 6.5% relative to the SPX (and nearly 10% since yearend 2020).

The rationale for moving to a market-weight position in RTY was that after major selloffs, it has tended to outperform the SPX for roughly a year before settling into a market-perform pattern (Chart 2). The black line is the average return relative to the SPX after eleven selloffs since 1987 where the RTY fell by more than 10% than the SPX. In 2020, RTY recovered from the April 2020 low (relative to the SPX) in line with history until the election, then zoomed higher, gaining 38% versus a typical 10%.

Powerful Russell 2000 Rallies Last About a Year

Granted, the post-selloff performance of RTY has varied considerably. But still, the 2020-21 experience has been truly extraordinary (Chart 3). The average line obscures much information, but whatever happens during the first year, the RTY relative return tends to flatten after a year. A few comments on some of the selloffs:

• The spikes after the October 1998 and March 1999 selloffs happened after the dot-com bubble started to deflate, and the SPX fell while the RTY traded in a range for some months.
• The poor performance of RTY after the August 1996 selloff was because the SPX was in thrall to the dot-com bubble.
• After the December 2018 selloff, the RTY underperformed as the Fed cut rates in an effort to keep a fading recovery alive.

One obvious reason for the strong relative performance of the RTY since the election was the sheer magnitude of the March 2020 selloff. But the immediate drop was about 15%, not 40%. Probably the more relevant benchmark is late 2018 before the year-end selloff (Chart 4). By that metric, the RTY is approaching 110% relative to the SPX, which is to say it has finally nearing the 2018 peak.

We note that over the past decade the RTY has rallied further relative to the SPX but it has not been able to sustain gains much above the 110% level. We regard this as another technical indicator that the RTY’s meteoric ascent has pretty much run its course.

RTY Has Momentum Going for It

We are constructive on equities generally. Given the prospect of $1.9 trillion of stimulus funds entering the economy in coming quarters, it is all but impossible to be bearish. The worst case for now appears to be a trading range market with some volatility until investors better understand the extent to which the stimulus is fostering sustainable growth and vaccines are controlling Covid-19. As the outlook for these twin uncertainties becomes clearer, markets will respond accordingly.

We see little more upside for the RTY versus SPX trade. We are by no means bearish on RTY versus SPX; rather we are neutral.

That said, momentum may well support the RTY index for now. We continue to be long RTY ETFs such as IWM or VTWO for the present.