SPSM - IWM: Why The Small Cap Bounce May Continue

2023-11-25 02:24:52 ET

Summary

• Small-cap stocks have rebounded from October lows, but overall returns have been disappointing compared to other indices.
• The iShares Russell 2000 ETF offers exposure to small US companies and has a low expense ratio.
• The fund has a balanced sector allocation and tends to rally at the beginning of the year, but volatility is common.
• I highlight key price levels to watch on this range-bound ETF.

Small-cap stocks have enjoyed quite the rebound off their October lows. The iShares Russell 2000 ETF (IWM) has risen slightly more than 10% from its intraday bottom on October 27 to the closing price as of Wednesday, November 22. Diversified investors indeed had something to be thankful for, but when you zoom out the performance analysis, returns have not been so delicious.

I have a buy rating on IWM. I see shares as bouncing off key support in the short to intermediate term, while the long-term valuation case appears strong on this low-cost fund.

Turning back to the chart, short-term Treasury bills have actually outperformed the small-cap index fund so far this year, making both absolute and relative returns very paltry compared to the Nasdaq 100's remarkably nearly 50% advance in 2023. Let's take a closer look at IWM as we head into year-end.

2023: QQQ +47%, BIL +4.4%, IWM Up Just 3.3%

For background, IWM offers investors exposure to small public US companies and access to 2000 small-cap domestic stocks in a single fund, according to iShares . The ETF can be used to diversify an asset allocation while seeking long-term growth.

IWM is a large ETF with more than $55 billion in assets under management and it pays a yield that is on par with that of the S&P 500's near 1.6% as of November 22, 2023. Share-price momentum is somewhat weak given this year's underwhelming performance, though the uptick over the past four weeks offers investors hope for a strong end to 2023. With a low 0.19% annual expense ratio , the ETF won't cost you too much, though it's possible to find comparable small-cap index products that feature annual expense ratios closer to 0.05%.

IWM is also seen as a risky fund given its high standard deviation and short interest percentage. Seeking Alpha notes that its annualized volatility is a high 20%. Liquidity is robust, though, evidenced by average trading volume of nearly 33 million shares and a median 30-day bid/ask spread of just a single basis point.

Digging into the portfolio, the 2-star, bronze-rated fund by Morningstar plots on the lower tier of the style box with balanced exposure across value, blend, and growth. The small-cap space generally trades with a low-teens forward operating earnings multiple, but you must consider that roughly 40% of small-caps have negative earnings, many of them known as "zombie companies," or firms that generate only enough cash to service interest on their debt obligations.

Small Caps Valuation: Priced Cheaply, But Watch Out For the Zombies

Russell 2000: High Percentage of Negative-Earners

The Russell 2000 index includes some of these non-earners, so you can also look to the S&P SmallCap 600 as that index has a profitability screening to get into the index. Of course, once in the index, a firm could turn negative in its profitability readings and remain in the index.

IWM: Portfolio & Factor Profiles

IWM differs significantly from the S&P 500 in its sector breakdown. There's much more exposure to cyclicals and non-growth slices of the market. While its largest sector component is, like the SPX, the Information Technology area, I.T. is just 16% of IWM versus closer to 30% of SPY. Overall, there is a more balanced allocation across sectors compared to the large-cap index.

IWM: Sector Exposure & Dividend Information

Seasonally, IWM tends to rally into the first week of a new year, but then weakness often occurs through mid-March. We saw that play out over the past 12 months when IWM jumped to cap off a weak 2022, but short-term gains were partially given up by the middle of March when the SVB crisis hit. So, the bullish seasonal tailwinds could be fleeting once the calendar flips to 2025, according to data from Equity Clock .

IWM: Bullish Seasonal Trends, But Early-Year Volatility Is Common

The Technical Take

You won't find many messier charts out there than IWM's. Notice in the graph below that shares have been stuck in a frustrating trading range since Q2 of 2022. Over the past 18+ months, the fund has traded between the low $160s and around $200. The bears got excited this past October when IWM threatened to break down under key support, but the bulls swooped back in. With the ETF now having its troubles around the 200-day moving average, there is still work to do. Still, given the bounce so far, I suspect IWM will eventually make a move back toward $200 over the coming weeks and months, perhaps driven by the Fed being done hiking rates.

But also take a look at the volume by price indicator on the left side of the chart - there's significant congestion at current levels - that will make it tough for the bulls to lift the fund in a sustained manner. A breakout above $205 or so would lead to a bullish measured move price objective to its all-time high notched more than two years at above $244. A bearish breakdown under $160 would have a target near $120, though.

Overall, I lean bullish for a rally to $200, but gains should be taken there until we see that definitive breakout.

IWM: Shares Rally Off Support, Eyeing $200 Again

The Bottom Line

I have a buy rating on IWM. I see a continued rally in the fund over the next several weeks and months while its long-term valuation case is attractive, though other, lower-cost funds could be used for domestic small-cap exposure.

For further details see: