US small caps seen on the verge of resurgence
THE E-mini Russell 2000 Index Futures contract represents the small-cap segment of the US equity universe. After lagging for most of 2023, small caps sprang to life in the final months of the year, as the contract rebounded from a 5.8 per cent loss at the end of October to end 2023 with a 15.6 per cent annual gain.
This amounts to a 22.7 per cent surge in the E-mini Russell 2000 Index Futures contract for the final two months of 2023, significantly outperforming the S&P 500’s 14.1 per cent and the Magnificent 7’s 16.0 per cent respective gains. Much of the year-end rally was driven by growing optimism that the Federal Reserve will cut interest rates in H1 2024 as the economy achieves a soft landing where inflation cools sufficiently without triggering a recession. This rejuvenated the small-cap segment of the market, as investors began seeking bargain-buying opportunities. Concurrently, the substantial rally in large caps may have also left them overvalued and vulnerable to profit-taking.
Entering 2024, we are bullish on small caps and expect the E-mini Russell 2000 Index Futures contract to hit 2,266 to 2,280 by mid-2024, driven by a favourable combination of fundamental and technical factors. With a Fibonacci Retracement drawn from the November 2021 high, our bullish thesis is validated if the contract closes above the key support-turned-resistance level around 2,049 to 2,050.
Fundamentally, we expect the end of Fed tightening to lead to a growth recovery that should benefit economically-sensitive small caps. Most of the headwinds faced by small caps, including high interest expenses and inflationary pressures should begin to ease in 2024. Historically, small caps also tend to outperform large caps during recovery periods.
From a valuation perspective, small cap valuations are currently more attractive. As at Jan 11, the S&P 500 is trading at a Last 12 Months (LTM) price-earnings (P/E) ratio of 23 times, compared to a LTM P/E ratio of just 18.9 times for the S&P 500 Equal Weighted Index, which weighs all 500 companies equally, effectively serving as a proxy for small caps.
From a technical perspective, the E-mini Russell 2000 Index Futures contract looks to have retraced from its previous breakout of the 50 per cent retracement level around 2,049 to 2,050. This level, once a vital support that was broken in early January, now serves as a key support-turned-resistance level. However since then, the contract has been unable to break through the 38.2 per cent retracement level, and appears to be rebounding back to the aforementioned 2,049 to 2,050 level. Some other key technical observations supporting our bullish thesis include:
- The Relative Strength Index (RSI) indicator is in bullish territory at around 55. We believe the contract has further upside before reaching the overbought level of 70. As long as the RSI remains at or above 50, the bullish momentum remains intact.
- The formation of a “Golden Cross” further validates our bullish view. The 50-Day Moving Average crossing above the 200-Day Moving Average is typically indicative of strong bullish momentum.
- The contract is trading above its 50, 100, and 200-day moving averages.
In summary, we maintain a bullish stance on the E-mini Russell 2000 Index Futures contract and expect it to bounce from the 38.2 per cent retracement level to trend higher and challenge resistance at the 50 per cent retracement level at 2,049 to 2,050. If this level is broken, we expect to see the contract head higher towards the 76.4 per cent retracement level around 2,266 to 2,280.
The writer is investment analyst at Phillip Nova
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