Until the other day, it had been almost three years since small-cap stocks and the Russell 2000 index made new highs. Meanwhile, the largest companies comprising the S&P 500 index have already done it over a dozen times this year alone. But the trend is changing, and the data is backing it up. Small-cap indices are knocking on the door, ready to break out much higher. Last month we discussed how small-caps were leading the charge with the help of things like regional banks and industrials creating relative strength for the index when compared to large-cap indices. More factors are lining up, adding fuel to the trend. The Fed is cutting rates, giving a boost to smaller companies with thinner customer bases who typically are more reliant on credit than their cash-cow big brothers. So even small moves in interest rates affect them much more. Traders seem to be taking notice and momentum is picking up. We are already seeing speculative growth stocks go on a tear in things like uranium, Bitcoin miners, and quantum computing. Globally, small caps are already taking the reins in countries like China, Brazil, and others. Seasonality should also start to come into play for the year-end, as the fourth quarter tends to favor small-caps historically.
After years of outperformance by the mega-cap leaders of the S&P 500 and Nasdaq, the Russell 2000 has some catching up to do, and that could bode well for the little guys. There’s an old adage on Wall Street, “the bigger the base, the higher in space.” With the small-cap index pushing up on new highs for the first time in almost 1000 days, this marks the longest drought for the index ever. And the relative underperformance has gone on even longer. This makes for a very long base that could serve as a launchpad. Even coming out of the 2008 financial crisis it only took 959 days to retrace the losses. Currently, we sit at a logical time in the cycle (middle of the bull market) and at a logical weighting (large caps are at their heaviest weighting in the indices in over 20 years) for the trend to shift. Long, secular trends like this are great to catch because they can carry on for years. It will take a while for money managers to unwind their heavy weightings in the large-cap space. After all, these are the biggest and best companies in the world, and they have dominated the market for years.
Large endowment funds and institutions move very slowly, and it may take many cycles of outperformance by the non-Mag-7s for money managers to meaningfully change their allocations. While it is important to pay homage to the ones that have produced the biggest gains, it’s also important to stay sharp and identify areas of potential outperformance. Pairing that with core holdings (often mega-cap) is an effective way to maximize growth and minimize taxes. Just like in sports, positioning matters. Putting yourself in position to make a play is more than half the battle. We are still in the early innings because the media outlets are not talking about it being “small-cap season.” That usually happens late in the trend. And as long as we continue to see record levels of “short interest” in small-caps while their indices charge to new highs it lets us know that we are in position to capture further gains. Anyone that is “shorting” a stock is just a guaranteed buyer in the future. Given the recent trends, the odds are they will be buyers at higher levels than today.