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Are Small Caps a Sleeping Giant Right Now?

Small caps have outperformed amid a high interest-rate environment

Managing Editor
Oct 15, 2024 at 1:09 PM
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Subscribers to Chart of the Week received this commentary on Sunday, October 6.

Small cap stocks were a feel-good story back in the summer, a feather in the cap of a resilient economy. The Russell 2000 Index (RUT) was reclaiming $2,000 and looking to make a run at 2021’s record highs near $2,400. The RUT, moving in lockstep with the S&P 500 up the charts, was even more noteworthy given how sensitive small caps are to sticky inflation data and the high interest-rate environment Wall Street was in just three months ago. With a solid technical foundation in place, investors were eager to see how small caps would react once the Federal Reserve got moving on cutting rates.

Investors are still waiting. After a 10.1% monthly gain in July, the RUT is 3% off its July 31 three-year high of $2,299.99. While all the other major indexes were melting up in September, the RUT was on the sidelines, only adding 0.6%. An aggressive central bank should have been a green light for small caps, the same way China’s new stimulus measures provided a shot in the arm for Chinese ADRs. So are small caps asleep at the wheel, or a sleeping giant ready to burn bears?

Per the iShares Russell 2000 ETF (NYSEARCA:IWM) chart above, note the two false starts in the last two months, looking almost as if small caps had priced in the Fed’s aggressive rate-cutting earlier in the summer. Even after this three-month pullback and subsequent consolidation, IWM is still up 10.3% in 2024. If the +10% year-to-date ends up holding this week, that’s another layer of support in place, in addition to the ETF’s 50-day moving average, as seen above.

IWM Chart COTW

However, the same chart also flags a double top from the August and September highs, signaling a potential bearish reversal trend. With IWM’s emphatic 1.4% gain on Friday –likely fueled by the producer price index (PPI) assuaging concerns of sticky inflation – the IWM is making another run at those two recent highs at $225. We’ll know sooner rather than later if this double top will be formidable in faking out investors.

There’s an alarming amount of pessimism surrounding IWM and some of its components. Per the chart below from Senior Quant Rocky White, data from September shows short interest on the IWM is at six-year highs. And while bearish bets leveled off from the last report, in the last 12 months, short interest increased by 25.6% and sits in the 96th percentile of its annual range. Options activity shows a similar put skew, albeit less elevated. In the last 10 days, 577,799 puts and 430,630 calls changed hands. That’s a large chunk of pessimism that could unwind, quickly, should the U.S. economy move in the right direction, and IWM overcome that double top technical hurdle.

IWM Short Interest COTW

Two small-cap names within the IWM stand out for their short squeeze potential. Salad restaurant Sweetgreen Inc (NYSE:SG) and semiconductor stock Semtech Corp (NYSE:SMTC) have 18.1% and 10.3% of their total respective floats sold short. At each stock’s average pace of trading, it would take shorts roughly five days apiece for shorts to buy back their bearish bets, an ample amount of buying power that could hit the market and fuel an unwind.

SG could already be squeezing shorts, adding 4.1% on Friday, and hitting a more than two-year high of $39.75. The shares are up 245% year-to-date, powered by three-straight post-earnings pops of 28% or more. With earnings in less than a month, this might be the last time to take a flier on the small cap before it enters another stratosphere. SMTC is up 95% in 2024, with its 6.5% October correction from a Sept. 26 two-year high of $49.53 currently testing its 40-day moving average. The company won’t report earnings until December but has scored five positive post-earnings reactions in the last six reports.

SG SMTC Stock Chart

The longer-term look at IWM’s chart in 2024 shows a pattern of higher highs in an uptrend channel. That double top is concerning in the short term, as is the weight of short sellers piling on. But if patience is exercised through these choppy waters, it could set up small caps for a cheerful holiday season.

 

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