It's not tech's market anymore. Small-caps are back in the game.

  • By Evie Liu,
  • Barron's
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As stocks have surged back from their lows this spring, small-cap companies haven’t kept pace, raising doubts over how long the rally can last. Now, though, market watchers are breathing a tentative sigh of relief.

When the large-cap S&P 500 (.SPX) hit its record closing high on Sept. 2 with a 11% year-to-date gain, the small-cap Russell 2000 (.RUT) was still down nearly 5% for the year. The market’s strength was primarily driven by expensive growth stocks such as Apple (AAPL), while most others were left behind.

But since tech stocks began to sell off in September, briefly sending the broader market lower, smaller stocks have begun to catch up. Since Sept. 23, the Russell 2000 has risen nearly 13%, outperforming the S&P 500 by 4 percentage points. The small-cap benchmark is now approaching its year to date high of 1705.2, set in January, and is only 100-odd points below the record it reached in 2018.

The comeback is a positive sign that investors are starting to gain confidence in the economy’s broader health, not just a few successful companies. There have been only 20 distinct times over the past 40 years when the Russell 2000 shot higher by at least 10% over a 10-day stretch, wrote Sentiment Trader’s Jason Goepfert in a newsletter last Friday.

Historically, rapid small-cap rallies like this have led to a positive return a year later almost 90% of the time. The median percentage gain has been in the midteens.

Canaccord Genuity analyst Tony Dwyer pointed to a few other signals of a broader market upswing. The ratio of stocks on the New York Stock Exchange moving up relative to those declining has reached a record high, he said. The percentages of S&P 500 components trading above their 10-day and 200-day moving averages have also been picking up.

“The broadening rally reinforces our positive core fundamental thesis,” wrote Dwyer in a note last week, “The strength of the broad market driven by the economic recovery beneficiaries has been dramatic.”

While the market may remain volatile into the end of the year, he believes excess liquidity in the economy—cash pumped in by central banks to counter the effects of the pandemic—and a synchronized global recovery should support positive fundamentals in the medium term. “Inevitable periods of weakness following these types of ramps should be used as an opportunity to add equity exposure,” wrote Dwyer.

Small-caps have historically responded strongly to hints that inflation is picking up, as it now appears to be, according to Doug Ramsey, chief investment officer and portfolio manager at the Leuthold Group. There has been a close relationship between small-caps’ relative performance and long-term inflation expectations, but the market has seen a disconnect between those two over the past several months.

“Any closure of the gap would massively benefit small-cap and multi-cap managers,” he wrote.

Of course, there is no guarantee how that gap might be closed. Small-caps are cheap enough that they could certainly go up considerably more, wrote Ramsey, but the large-cap growth stocks that dominate the S&P 500 are so overvalued that they could rise more slowly, or even drop, especially if bond yields pick up again in response to the inflationary expectations.

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