The last several years have been spoiled with all-time highs, and while most of the market had joined in the fun, small caps had yet to do so… until now.
The last several years have been spoiled with all-time highs, and while most of the market had joined in the fun, small caps had yet to do so… until now. Last week ended a nearly four year streak of the Russell 2000 failing to close at a new all-time high, which is the second longest streak in the index’s history. During the almost four years in which the Russell 2000 didn’t set a high, the S&P 500 was up 42% while the Nasdaq-100 rose 50%, highlighting the persistent lag of small companies in recent years. With the small cap dam potentially breaking loose, could we expect the group to reverse course?
Last week marked the twelfth instance in which it took the Russell 2000 longer than a year to close at a new all-time high. Looking at the forward returns following previous streaks ending, the near-term performance of the index tends to be strong. The three-month return average was 8.3%, which is more than three times the historical three-month average return. However, long-term returns tend to slow down after that, with the six-month return barely higher than the three-month mark. While breakouts have often signaled short-term momentum, they haven’t necessarily indicated long-term strength
We know that small caps have seen renewed optimism in recent months, but which areas within the group have been driving the upside? The S&P Small Cap 600 is another small cap index that selectively focuses on more profitable companies in the small cap space. This year has seen a notable preference for the Russell 2000, with it outpacing the S&P index by more than 6%. The iShares Russell 2000 ETF (IWM) also holds a fund score that is a full point higher than iShares S&P SmallCap 600 Index Fund (IJR), showing their notable difference in relative strength as well. Outperformance in favor of the Russell is a potential sign that more speculative and less profitable growth stocks have led the way to the upside.
Comparing small cap growth and value funds furthers this notion, with the two groups looking noticeably different in strength. The iShares Russell 2000 Growth ETF (IWO) has an extremely strong fund score of 5.57, which is 1.82 points higher than the average small cap fund. Additionally, it holds a score direction of 5.16, highlighting its significant increase in strength. Meanwhile, the iShares Russell 2000 Value ETF (IWN) lags in comparison with a fund score of 3.29 and a score direction of 2.89. While both small cap styles have improved in recent months, the magnitude of improvement from growth has been far greater than value.
Not only are there notable differences in the strength of small cap styles but also within different sectors of the group. Like the broader DALI rankings, the risk-on small cap sectors look the most attractive for the time being. Looking at the X lineup of small cap sector ETFs, Technology, Industrials, Discretionary are the three strongest by fund score. Meanwhile, defensive sectors like staples, healthcare, and utilities remain extremely weak with scores below one. For the time being, large caps continue to hold more long-term strength than small caps. However, there are still small cap areas that go toe-to-toe with large caps. The Invesco S&P SmallCap Industrials ETF (PSCI) holds a fund score of 5.49—almost half a point higher than the Industrial Select Sector SPDR Fund (XLI). Meanwhile, the Invesco S&P SmallCap Materials ETF (PSCM) is noticeably stronger than its large cap counterpart, driven partially by the small cap fund’s higher exposure to mining companies, which have been some of the market’s best performers this year.
It has yet to be seen whether the recent outperformance from small caps will manifest into long-term strength. However, risk-on areas and certain sectors within the small cap space make a compelling addition for portfolios hoping to ride the small cap wave.
