The Russell 2000 Index's (RUT) recent win streak could suggest stocks are overheating
The Russell 2000 Index (RUT) just had its longest winning streak in over 20 years. Consequently, the relative strength of the small-cap index compared to the S&P 500 Index (SPX) has reached an eight-year high. Have similar small-cap surges been a positive sign for the market, or have they signaled an overheated market set to pull back? I'll look at similar situations from the past to try to answer that question.
Russell 2000 Winning Streak: We have data on the Russell 2000 since 1979. This is the fifth time the index has reached a winning streak of 15 straight trading days. The table below shows some data on each of those past occurrences. The return during this recent streak of over 16% was by far the highest of all the streaks. The only other time the return during a streak reached double digits was in 1985. After that streak, RUT continued higher for the next two weeks and then pulled back from that point over the next several weeks. Overall, the returns look pretty bullish. The index is higher after each of these winning streaks a month later, with a "low" return of 1.83%.
I wanted to see whether long winning streaks signaled an overbought market. To get more signals than the handful above, I looked at what happens after a winning streak of 10 or more days ends. The table below shows there have been 33 other signals, and it summarizes the returns after these. From the tables, it looks like these winning streaks don't lead immediately to a pullback. One month after the streaks end, the Russell 2000 averaged a gain of 1.73% and was positive about 73% of the time. These are pretty bullish figures compared to the anytime returns since 1979. However, look at returns after three months. The index averages a return of about 1% and has been positive barely half the time. Typically, the index averages a 2.77% return and is positive 63% of the time. Perhaps these streaks indicate an overheating market due for a pullback, but they tend not to happen immediately.
Small-Cap Relative Strength Surge: The recent small-cap rally has led to the highest 21-day relative strength in about eight years (the Russell 2000 relative to the big-cap S&P 500 Index). In the chart below, a reading of 100 means RUT and SPX have the same return over the past month. While the chart isn't all that easy to read, it does illustrate the current extreme reading.
To find the implications of the spike in small-cap relative strength, I went back to 1979 and found all times the reading hit 108 (it had to be the first such reading over a three-month span). Then I tracked the return of the index following such readings. The summary of the returns is quite convoluted. A week after the surge, the index averaged a loss of over 1%, but was positive almost 70% of the time. This would suggest heavy losses when there were in fact losses. One of the signals was Black Monday (Oct. 19, 1987, when the S&P 500 fell almost 30% in a single day). After this signal, the Russell 2000 fell over 17% the next week.
After getting rid of the outlier 1987 signal, the summary of returns is in the table below. Similar to the returns after the streaks, the returns out to one month are relatively bullish. However, the three-month returns underperform. In fact, in four of the last five occurrences dating back to 2000, the small-cap index was down at least 6% three months after a signal. Hopefully, that's not the case this time.
Finally, the tables below show how the S&P 500 has performed after small-cap relative strength spikes higher. The returns are pretty mild for the first month after the signals, showing returns not too far off from the typical SPX performance. Again, though, the three-month return has significantly underperformed its at-any-time return.
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