Two weeks ago I wrote that you should not fear the Russell 2000 “death cross.” This event happened when the index’s 50-day moving average (DMA) crossed below its 200 DMA.

It’s rumored to be a sign that the broad market is in trouble since small caps, as a riskier asset, are often thought to be a leading indicator. But as I recently wrote, the data shows that trading into small caps when this technical event occurs will, more often than not, lead to profits in the following months.

small-cap-stocks

That’s according to 30 years of data from Sentiment Trader. The data shows that investors would have made money 69% of the time if they bought right after the death cross occurred, and held for six months.

The average return would have been 13.6%.

Given that the Russell 2000 just completed a death cross, I thought it timely to present a little more evidence supporting the potential for small cap stocks to rally in the next six months.

Here’s the most important thing to understand: What matters most isn’t the death cross event, but the context within which it occurs. If the economy is entering recession and the market is tanking, then you’re obviously not going to want to place this trade.

But if the general market outlook is fair to positive, as it is now, you will.

Small cap stocks had a heck of a year in 2013, with the S&P 600 Small Cap Index rising by 34% as compared to 25% for the S&P 500. But the asset class has been a dog so far in 2014, falling by 3.4% as compared to a 7.7% rise in the S&P 500.

I don’t’ think this dynamic will last much longer. When the reversal comes, small caps are going to lead the market higher . . . especially since valuations for the asset class have some way down.

According to Yardeni Research, the S&P 600 Small Cap Index is now trading with a forward P/E of 16.8. This is not expensive during times of relatively stable markets and GDP growth. And the valuation has come well off of the highs around a P/E of 19 hit early in the year.

Small caps are now trading essentially in line with mid-cap valuations – the S&P 400 Index has a forward P/E of 16.5. I don’t expect that they’ll stay neck and neck for long.

If you put a small-cap trade on to play the potential rebound, the easiest way to go is with an index ETF. My advice is to go with a Vanguard ETF, which tracks the Center For Research In Security Prices (CRSP) U.S. Small Cap Index, or an iShares ETF that tracks the S&P 600 Small Cap Index.

I much prefer either of these options over any ETF that tracks the Russell 2000 index. I don’t like the way the Russell is constituted, and it is trading at a premium right now with a forward P/E of 22. The S&P 600 is a comparative value at the moment.

Aside from the most recent Russell death cross, the event has happened seven times in the last ten years. When the market was collapsing in 2007 and 2008, buying small cap stocks would have led to near-term losses, just like almost any equity investment would have.

But buying small caps the other five times led to an average gain of 18.1% in six months. And the most profitable trade, in 2010, resulted in a 22.2% return. That’s the type of potential I see right now.

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