ETF Trends
ETF Trends

Small-cap stocks and the relevant exchange traded funds confounded in investors confounded investors last year as the iShares Russell 2000 ETF (NYSEArca: IWM) gained just 5% compared to a 13.5% jump for the S&P 500.

IWM has not been much to squawk about this year, trading modestly lower, but the ETF’s recent lethargy could be more consolidation than an ode to disappointment. And that consolidation could be ready to give way to a significant move to the upside for the benchmark small-cap ETF.

“The first chart shows the weekly candlesticks in a sideways range over the past 16 months. We have now tested the upper end of this range four times since it first peaked in March of last year. The more times that a level is tested, the higher the likelihood that it breaks. I believe an upside breakout is coming any minute and we want to be buyers of that breakout. The catalyst, to me, is the failed breakdown in October below support from last February and May near 1080,” notes Eagle Bay Capital Founder J.C. Parets.

Chart Courtesy: J.C. Parets, Eagle Bay Capital

Fundamentally, small-caps offer some allure as resilient strong dollar plays. Most smaller companies are not exposed to foreign exchange risks and the strengthening dollar. According to Bank of America Merrill Lynch, 81.3% of revenue from the Russell 2000 Index is generated within the U.S., whereas 64.3% of revenue for S&P 500 companies come from the states. [Small-Cap ETF Optimism]

Smaller companies have been increasing capital expenditures, which would allow them to capitalize off an expanding economy. Small-caps are also raising cash returns to shareholders. Additionally, small-capitalization stocks are more likely to benefit from merger and acquisition activity. And the technicals look compelling.

“The upside target based on this consolidation is above 1320 which represents the 161.8% Fibonacci extension of the entire correction from last year. This represents around 10% from current levels. Risk management-wise I don’t see any reason to be long if we are below all of this overhead supply from the past year. But above it and we want to be all over it. The best part is how well-defined the risk becomes upon an upside resolution,” adds Parets.

Small-cap naysayers are apt to point to high valuations as a headwind. Despite falling behind large-cap shares in 2014, fund managers and analysts are warning that small-cap stocks are trading at valuations above long-term averages, reports David Randall for Reuters.

Steven DeSanctis, an analyst at Bank of America Merrill Lynch, believes that Russell 2000 companies look expensive relatively to historical averages as the trailing price-to-earnings ratio of the Russell 2000 hovers around 22.7, or 40% more than its long-term average of 16.2. [Small-Cap ETFs Look Pricey]

ETF Trends editorial team contributed to this post. Tom Lydon’s clients own shares of IWM.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.